Dubai World has fuelled the emirate's rapid economic growth of recent years
European shares have been hit by concerns over Dubai's financial health, after a government-owned company asked for an extension on repaying its debts.
The UK's FTSE 100 index lost 3.2%, its biggest one-day fall since March, after Dubai World asked creditors to postpone upcoming repayments until May 2010.
Banks were hit particularly hard on concerns over Dubai's ability to pay back its debts.
Share indexes, however, are trading at their highest levels for over a year.
"Certainly the Dubai debt debacle and the uncertainty that it has created has had a severe knock on effect," said David Buik at BGC Partners.
The FTSE 100 finished Thursday trading at 5,194, which in points terms is a decline of 170.7.
Barclays was the biggest faller, down 8%, followed by Royal Bank of Scotland, which lost 7.8%.
French and German shares also declined, with France's Cac index ending down 3.2%, and Germany's Dax losing 3.4%.
A senior Dubai government official, Sheikh Ahmed bin Saeed al-Maktoum, chairman of Dubai's Supreme Fiscal Committee, said he understood the concerns in the markets, but that "decisive action" was needed to address Dubai World's debt problem.
"The government is spearheading the restructuring of this commercial operation in the full knowledge of how the markets would react," he added.
After six years of rapid growth, the reputation of Dubai's economy is now being questioned.
"Dubai could not undermine itself any further as a place not to do business in at the moment," said Manus Cranny at MF Global.
"It is the much longer term implications on funding, confidence and capital raising that will take a decade or more to re-establish," he added.
Analysts say the Dubai government has paid the price for a flamboyant economic model centred on foreign capital and giant construction projects.
Dubai World, which has total debts of $59bn (£35bn), has asked for a six-month extension on debt repayments.
It was due to repay $3.5bn next month.
The Dubai government said the request to delay debt repayments also applied to property developer Nakheel, a Dubai World subsidiary.
"It does come off as a little bit of a surprise," said UBS Bank analyst Saud Masoud.
"I think the expectation throughout the year has been at least that the Nakheel debt repayment was a given, [that] one way or another Dubai would be able to raise the capital to finance that debt."
"It really tests investor confidence significantly."
The debt delay plea has led to major credit ratings agencies downgrading a number of state-backed Dubai companies.
"In our view, such a restructuring may be considered a default under our default criteria, and represents a failure of the Dubai government to provide timely financial support to a core government-related activity," said Standard & Poor's.
Dubai is one of the seven self-governing emirates that make up the United Arab Emirates.
Some have speculated it is likely to turn to the more economically conservative Abu Dhabi emirate to bail it out.