The London Stock Exchange said it was investigating the “root cause” of the problem and would update investors when it had further information.
Elsewhere, Frankfurt dived 1.80 percent to 5,698.99 points and Paris plunged 1.89 percent to 3,737.06 points at the half-way stage.
In Asia, Beijing nosedived 3.62 percent, Tokyo fell 0.62 percent and Hong Kong closed 1.78 percent lower. Chinese shares were also hit by the prospect of tighter banking rules and worries about monetary policy next year.
New York markets is closed Thursday for the Thanksgiving Day holiday in the United States.
“We have two major factors weighing on equities and other risk markets: Dubai’s call for a moratorium on its debt repayment to May and more stringent capital adequacy requirements for Chinese banks — but Dubai is bigger,” David Morrison, an analyst at financial betting firm GFT, told AFP.
The government of Dubai shocked financial markets on Wednesday when it said it would ask creditors of its Dubai World conglomerate for a debt moratorium of at least six months.
The Dubai government announced that it would revamp the Dubai World group and wanted its lenders to extend its maturing debt until at least May 2010.
Dubai added that it had raised five billion dollars in a new bonds issue aimed at helping meet its debt obligations.
“Dollar weakness … sent Asian markets plunging, which then took European exchanges with them,” said Xavier de Villepion, an analyst with Global Equities in Paris.
In addition, the partial default by Dubai “fed a climate of insecurity and crisis of confidence at a time when fears are mounting about excessive public debt.”
As equities sank heavily, investors sought safety in the bond market and gold, which struck yet another record high point.
“It’s causing a mini flight-to-quality as US, European debt gets bought as a relative safe haven,” noted Morrison.
He added: “If (Dubai) had given the debt markets more warning, then there would be less of a panic now.”
Meanwhile, ratings agency Standard & Poor’s said the development could be considered a default and downgraded a raft of Dubai government entities including Dubai World.
“The rating actions are the result of the announcement on November 25 of the restructuring of the debt obligations of Dubai World and its subsidiary, (construction group) Nakheel,” S & P said in a statement.
“In our view, such a restructuring may be considered a default under our default criteria, and represents the failure of the Dubai government to provide timely financial support to a core government-related entity.”
Barclays Capital analyst Paul Robinson warned that the issue of Dubai could contribute towards a “serious” pullback in global stock markets.
Others warned that it could take more than a decade for investor enthusiasm over Dubai to return, as a result of this week’s development.
“Dubai could not undermine either itself, or global perception any further as a place not to do business in at the moment,” MF Global analyst Manus Cranny told AFP.
“Quite literally, this geographic region is now looking as a mirage in stability terms.”
He added: “It is the much longer term implications on funding, confidence and capital raising that will take a decade or more to re-establish.
“This last-minute moratorium on debt repayments at Dubai World is unacceptable has all the smacking of an Ireland — nay worse, an Iceland — in the making.
“The two regions may be polemic in climate but mirror images in terms of credit and ability to meet their bills.”
Elsewhere on Thursday, gold soared to a record high of 1,195.13 dollars an ounce after a purchase of IMF gold by Sri Lanka’s central bank, traders said.
The precious metal has also won support in recent weeks from inflationary fears, the weak US currency and increasing moves by central banks to diversify assets into gold.