Italy's borrowing costs surged into bailout territory as uncertainty over its political future weighed on markets.
The FTSE 100 Index was 1.7% lower as Italian 10-year bonds soared past the 7% mark to the same unsustainable levels that pushed Ireland and Portugal into a multibillion bailout from the EU and IMF.
The rise - a sign that investors have lost confidence in the country's creaking finances - came despite prime minister Silvio Berlusconi vowing to resign after key budget reforms are passed.
Kathleen Brooks, research director at Forex, said the market may be reacting to the potential for "a fractious coalition government getting into power", which could worsen Italy's fiscal situation.
The ongoing uncertainty in Europe continued to weigh on the banking and mining sector, with shares in Royal Bank of Scotland falling 4% and copper giant Kazakhmys dropping 3%.
Mr Berlusconi has confirmed he will not run again for office and his hand-picked successor Angelino Alfano will be his party's candidate when Italy holds new elections.
The markets initially posted modest gains after the move, which bolstered hopes for coordinated action on the debt-laden country's austerity drive.
Mr Berlusconi was largely seen as an obstacle to Italy, which is the eurozone's third-largest economy and has debts worth 120% of national income, pulling itself from a financial mire.
But the uncertainty over when the election will take place and the position any new government may take troubled investors, with the Cac-40 in France and Germany's Dax dropping more than 2%.
Meanwhile, uncertainty in Greece continued to weigh on the markets as the debt-laden country is yet to select a replacement for former Prime Minister George Papandreou, who stepped down amid increased criticism over his handling of his country's part in the debt crisis.
© 2011 Press Association