The FTSE 100 index of blue-chip shares dived 160.5 points, or 2.6 per cent, to 6,000.7, wiping nearly £40bn off the value of the UK's leading companies. It was the biggest one-day fall since last May and left the index at its lowest since the beginning of October. The sell-off came just as the FTSE 100 was starting to recover from last month's slump. Analysts warned that volatility was set to continue for several weeks.

The latest rout was sparked by concerns about the level of defaults faced by US sub-prime lenders such as New Century, which provide mortgages to people with poor credit. Figures have shown that late mortgage payments and home repossessions in the US are at their highest level since records began, while New Century, America's second biggest player, moved a step closer to bankruptcy yesterday as Barclays demanded it immediately buy back $900m (£465m) of mortgage loans. New Century has less than $60m of cash available, but could face demands to pay back more than $8bn.

The worry is that the problems in the sub-prime market will spill over to the rest of the US economy, causing a domino effect around the globe. " It really is now all about the sub-prime issue," said Peter Dixon, UK economist at Commerzbank. "We thought we were over the worst and now perhaps some of the old chickens are coming home to roost. We've got at least another two weeks to run of this bout of uncertainty."

Jeremy Batstone, at Charles Stanley, said: "The key issue at the heart of everything is just how robust the US economy is. UK banks have taken a hit because the financial sector is carrying the toxic waste of bad debt, which will ultimately result in lower profits. For now, the losses are being masked by strong trading operations. Given the extent to which confidence has taken a knock, it may be mid to late April before, barring any more catastrophes, investors can breathe easy again."

European bourses suffered similar losses, Germany's DAX and France's CAC 40 both tumbling by about 2.5 per cent. In Asian markets, Tokyo's Nikkei closed 2.9 per cent lower and indices in Hong Kong, Malaysia, India and Australia fell by more than 2 per cent. On Wall Street, the Dow Jones rallied at the opening bell but soon began sliding, falling as much as 135 points before rebounding after Europe closed. By the close, the Dow was up 57.4 at 12,133.4.

Investor wobbles spilled over to the foreign exchange markets, where sterling hit an eight-month low of 1.4631 against the euro. In the corporate bond market, credit derivatives linked to banks and risky high-yield bonds came under heavy selling pressure but the broader market kept its poise.

Magnus Mathewson, at Hichens, Harrison, said problems in the US sub-prime market spelt danger for the UK's housing market if they crossed the Atlantic. "The UK mirrors the US in that it has very high levels of personal debt and people have been borrowing to fund lifestyle rather than capital items," he said. "This suggests that the resilience of the UK housing market may well be tested for the first time since the late 1980s and early 1990s.

"Property is starting to look rather unaffordable, and we would keep a keen eye on the buy-to-let market, which we believe is by far the most vulnerable."

John Kriz, managing director of real estate finance at the ratings agency Moody's, said the crisis may herald an end to the glut of liquidity in world financial markets. "One wonders whether the stress being experienced in the sub-prime market is the bell ringing out the era of the incredible shrinking credit risk spread and the monsoon of liquidity," he said.

Jim Rogers, the co-founder with George Soros of the Quantum Fund, also warned of a US real estate crash that could spread contagion to emerging markets.

"You can't believe how bad it's going to get before it gets any better," Mr Rogers, who has put his Manhattan mansion up for sale and is planning to move to Asia, told Reuters yesterday. "This is the end of the liquidity party. Some emerging markets will go down 80 per cent, some will go down 50 per cent. Some will probably collapse."

But Stephen Pope, head of equity research at Cantor Fitzgerald, said the fears were overblown, pointing out that sub-prime accounted for only $1 trillion of the $8 trillion US mortgage market. "The market must be allowed to work its magic, and if people have lent without due diligence and care then they will reap what they sow," he said. "Once the bad companies are weeded out, then the rest of the market can get on with what it is doing."