Trading on India's main stock index, the Sensex, was suspended briefly on Wednesday after the market slumped 9%.
The fall came after the stock market regulator proposed urgent curbs on the flow of foreign funds into shares, in order to stop the market overheating.
The Sensex sank to 17,544.15, after Tuesday's record high of 19,174.45, but clawed back many of the losses to close 1.8% down at 18,715.82.
India's finance minister said that there was no need for alarm.
'Abundant investment'
The regulator's recommendation relates to participatory notes - a form of investment used by hedge funds and other foreign investors who are not registered in India.
"Investor sentiment is likely to weaken considerably as an important source of potential inflows has likely been plugged"
Analysts say the proposal may be aimed at countering a surge in foreign money that has caused Indian share prices to rise sharply - worrying some policy makers about its potential impact on the broader economy.
There is also a concern that because much of the investment is coming from unregistered firms, those investors could easily pull out, damaging the markets.
Finance minister P Chidambaram said that foreign investment was still welcome and that a ban on the notes was not intended.
"But presently it is important to moderate capital flows, which are getting very copious and abundant," he said.
Analysts at JP Morgan suggested that of the $17bn of foreign funds invested in India so far this year, about $10bn has been in participatory notes.
"Investor sentiment is likely to weaken considerably as an important source of potential inflows has likely been plugged," said Rajeev Malik, an economist at the firm.
And Shitin Desai of DSP Merrill Lynch said that the market was reacting nervously to a proposed regulatory move.
"This is the first step towards tighter norms for overseas funds, which is healthy."
India is seen by many investors as one of the safest havens among the emerging markets as investors try to tap into one of the world's best-performing economies.
The rupee has risen more than 11% against the US dollar since the start of the year. It stood at 39.31 to the dollar at Tuesday's close, but had weakened to 39.90 early on Wednesday.
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