The All Share Price Index closed down 3.24 percent (99.74 points) to end at 2,983.17, while the Milanka Index of more liquid stocks dropped 4.
34 percent (150.98 points) to close at 3,327.35, according to provisional stock exchange data.
Turnover was 763.7 million rupees.
The fall in share prices was initially triggered by the arrest on insider dealing charges Friday of billionaire US hedge fund manager Raj Rajaratnam, the Sri Lankan-born co-founder of the Galleon fund, who has big stakes in blue chips.
A European Union report Monday that said Sri Lanka was in breach of commitments to be eligible for the GSP Plus trade deal giving duty free access to EU markets also spooked investors.
"The combination of Rajaratnam's arrest and negative news on the GPS Plus concessions sparked panic retail selling which pulled the market down," said Waruna Singappuli, head of research at NDB Stockbrokers.
"Some positive news in expected in the third quarter interim results which should help the market as well as the second tranche of the International Monetary Fund facility.
"
This is the first time the market has taken such a sharp dip in the near past, brokers said.
Brokers said investors had been unnerved by the possibility Sri Lanka might lose duty free access to EU markets after the European Commission report criticised the government's human rights record.
The EU report said the EU might temporarily withdraw the GSP Plus trade deal which could erode the competitiveness of Sri Lankan exports and cause local exporters to lose European orders.
That report came soon after the arrest in the US of Rajaratnam.
Conglomerate John Keells Holdings closed at 140.
00 rupees, down 8.00, or 5.41 percent, and Commercial Bank of Ceylon closed 122.50 rupees, down 3.75 rupees. Rajaratnam has stakes in both firms.
Media reports said the Galleon Group hedge fund was facing heavy investor withdrawal requests after Friday's arrest of Rajaratnam.
They said the fund was moving to unload some of its technology stocks and other holdings to raise cash.
Index heavy stocks, Dialog Telekom closed at 7.
00 rupees, down 25 cents, and Sri Lanka Telecom closed at 44.25 rupees, down 75 cents.
"The negative reports on the GSP Plus concessions are impacting market sentiments," Thakshila Hulangamuwa, vice president at stock brokering house Asha Philip Securities said.
"Panic selling on the blue chip counters is weighing down heavily on the bourse."
Distilleries Company of Sri Lanka closed at 99.75 rupees, down 4.25 and Tokyo Cement closed at 224.00 rupees, down 25.75.
Hatton National Bank closed at 156.
50 rupees, down 12.50, and Sampath Bank closed at 185.00 rupees, down 5.00.
Diversified Hayleys which has a significant exposure to exports, closed at 151.
00 rupees, down 6.75.