© Reuters/Francois LenoirGeorge Papandreou has announced that there will be a Greek referendum to approve the EU bail-out deal which would impose a 50pc haircut on its creditors
London's FTSE 100 index of leading shares dropped more that 2pc, with markets in Germany falling, France, Spain and Italy sliding between 2.7pc and 4pc.
Andrew Lim, banking analyst at Espirito Santo in London, said: "If Greek voters reject the unpopular bailout plan it could result in a "hard default", which could force banks to take losses of about 75pc on their Greek sovereign bonds, trigger payouts on credit default swap insurance contracts, and raise the threat of a systemic risk.
"If we get a hard default in Greece, it will exacerbate the situation with Italy and Spain. It just increases the problem of Italy going down the same route, and that's the real risk.
The fall in Europe followed big falls on Wall Street overnight and in Asia, with surveys showing China's manufacturing remained sluggish also weighing on sentiment.
Japan's Nikkei 225 dropped 1.7pc to 8,835.52, Hong Kong's Hang Seng lost 2.5pc, and Australia's S&P/ASX 200 shed 1.5pc, despite the country's first rate cut - a quarter-point to 4.5pc - since 2009. The Dow Jones fell 2.3pc to close at 11,955.01. The S&P 500 fell 2.5pc to 1,253.30, and the Nasdaq composite fell 1.9pc to 2,684.41.
Prime Minister George Papandreou announced plans for the referendum in response to riots that followed last week's proposal, as well as dissent from within his own Socialist party.
He said: "The command of the Greek people will bind us. Do they want to adopt the new deal, or reject it? If the Greek people do not want it, it will not be adopted."
Staging a referendum, reportedly to be held in January, threatens to throw the eurozone further into crisis as the majority of Greeks object to the bail-out, according to a survey published last week.
If Greece were to reject the plan, which requires deep spending cuts, it would risk a full-scale default and possible ejection from the euro. The country could even run out of money to pay civil servants or state pensions if the troika decided to pull the plug.
The decision by the embattled Mr Papandreou has the potential to be a major blow to efforts by German chancellor Angela Merkel and French President Nicolas Sarkozy to tame a crisis that most economists expect to push Europe back into recession in coming months.
The move is also likely to rattle investors whose initial euphoric reaction to last week's agreement in Brussels has been replaced with a scepticism over whether European governments, including those of Greece and Italy, will be able to drive through the tough austerity measures demanded by the agreements.
The deal that European leaders and the IMF struck last week would see banks take a 50pc writedown on Greek loans, cutting the country's debt by up to €100bn, alongside a €130bn international rescue effort on top of the existing €110bn package. No dates have been set for the referendum, which would include a confidence vote in the government.
"Heightened Greek uncertainty could propagate to other fragile euro countries, in particular Italy," said Thomas Costerg, an economist at Standard Chartered Bank.
Mr Papandreou's move is a high-stakes gamble designed to win greater legitimacy for austerity that's proving deeply unpopular in a country where the economy is already forecast to shrink 5.5pc this year.
While polls show a majority of Greek voters see last week's rescue package as a "negative", they also signal that most would like to stay in the euro.
"I can no longer look at polls where the majority is against the agreement, the majority is against the programme, but a majority is also in favour of staying in the euro," Evangelos Venizelos, the Greek finance minister, said on Monday.
Meanwhile, Willem Buiter, chief economist at Citigroup has called for the EU bail-out fund to be increased to €3 trillion. Writing in the Financial Times, Mr Buiter said that "the €1 trillion figure bandied around ... assumes that a 20pc or 25pc first loss guarantee would reduce Italian and Spanish borrowing costs on new debt issues to sustainable levels. It would not."
Brilliant move on the part of the prime minister. By calling for a popular vote, he avoids any retaliation by the Greek people when the austerity measures are imposed. The "popular vote" will most likely be "adjusted" using methods learned from the US voting system, so the plan is passed.