Traders worldwide were spooked by the poor results at an auction of German debt, which drew too few bids to sell all of the 10-year notes being offered. Germany has Europe's strongest economy, and traders have bought its debt as a safe place to store value during turbulent times.
The weak buying suggests that Europe's crisis might be infecting strong nations that are crucial to keeping the euro currency afloat. Germany bears much of the burden of bailing out weaker neighbors such as Greece and Portugal.
Borrowing costs for Italy and Spain rose from levels that already were considered dangerously high. Europe lacks the resources to bail out those countries, which have its third- and fourth-biggest economies.
The Dow fell 209 points, or 1.8 percent, to 11,285 as of 2:20 p.m. Eastern time. The Dow has now given back more than half of its big October rally. It jumped 9.5 percent last month, the biggest gain since 2002.
The Standard & Poor's 500 index fell 24 points, or 2 percent, to 1,165. All 10 industry groups fell sharply, led by energy companies, materials makers and banks. The index is headed for its sixth straight decline, the longest losing streak since August.
The Nasdaq composite index lost 55, or 2.2 percent, to 2,466.
The dollar rose sharply against the euro as investors moved money into assets considered to be relatively safe. The euro fell below $1.34, from $1.35 late Tuesday.
Fears about Europe also dragged U.S. bank stocks lower. Investors were unnerved by the Federal Reserve's announcement late Tuesday of a fresh round of stress tests of the biggest banks, said Peter Tchir, who runs the hedge fund TF Market Advisors.
The Fed said 31 banks will be tested to see how they would withstand a recession that would push unemployment above 13 percent by early 2013. The jobless rate now stands at about 9 percent.
The announcement undermined weeks of market-boosting talk by Fed officials, Tchir said. The stress tests, apparently related to fears about European exposure, exposed a darker view of the market held by some central bank officials, he said.
"They went ahead and put weakness into the market for the first time" in months, Tchir said. "No one was that afraid, and now all of a sudden, they're saying `Our own Fed is worried.' That really spooked people."
Bank of America Corp., Citigroup Inc. and Morgan Stanley each lost between 3.5 percent and 4 percent. JPMorgan Chase & Co. declined 2.9 percent.
Asian markets fell earlier after a survey showed that manufacturing appears to be slowing in China. A day earlier, the U.S. government had lowered its estimate of third-quarter economic growth.
Relatively few shares were traded as many U.S. market participants got an early start on Thursday's Thanksgiving holiday. U.S. markets will be closed on Thursday and will have shortened hours on Friday.
In corporate news, Deere & Co. rose 3.6 percent after the company reported net income growth of 46 percent. Deere credited strong sales of farm equipment.
Groupon Inc. plunged 14 percent to $17.22, trading below its initial price of $20 for the first time. The online deals company went public less than three weeks ago.
Companies that make raw materials were hurt by signals of slower growth in China and worries that Europe might fall into recession. Aluminum maker Alcoa Inc. declined 3.9 percent. It switched off with Bank of America as the biggest loser among the Dow's 30 components. United States Steel Corp. dropped 5.8 percent.
Boston Scientific Inc. rose 1.3 percent after the government approved use of a drug-coated stent for patients with clogged arteries. The stent's approval came earlier than analysts expected.
The U.S. government released a mixed batch of economic reports before the market opened. Concerns about developments overseas appeared to overshadow a handful of hopeful signals.
Slightly more people applied for unemployment benefits last week, a sign that layoffs continue. However, the broader trend is positive. The four-week average fell for the eighth time in nine weeks.
Consumer spending grew by the least in four months. Yet incomes rose a bit more than expected. Orders for long-lasting manufactured products fell for a second month and business investment dropped off. But without commercial aircraft orders, a volatile category, orders actually increased.