'We issued a circular to financial institutions reiterating that the use of bank loans for stock investment is strictly forbidden,' one regulatory source said.

The Shanghai Composite Index, which measures A and B shares, fell 3.96 per cent to 2,857.36 points yesterday while the Shenzhen Composite Index dropped 4.28 per cent to 675.78 points.

The Shanghai/Shenzhen 300 Index, which is regarded by many industry professionals as the new benchmark, declined 3.3 per cent to 2,452.63 points.

'Illegal financing is a mainstay of the Chinese markets,' said Fraser Howie, a co-author of Privatizing China: The Stock Markets and Their Role in Corporate Reform.

'This measure has spooked the market because it indicates to investors the State Council thinks the market's overheated and at risk of forming a bubble.'

The market was also driven down by speculation the central bank may raise interest rates earlier than expected after headline inflation climbed to 2.8 per cent last month.

A-share turnover exceeded 136 billion yuan for the day, well off the record high of 152 billion yuan reached on Monday.

However, the three companies with the largest trading volumes all closed higher. Shanghai International Port Group gained 4.21 per cent, Citic Securities rose 1.67 per cent and China Minsheng Banking Corp added 1.21 per cent.

But other large-cap companies fell. Industrial and Commercial Bank of China dropped 4.52 per cent, China Life Insurance dived 6.97 per cent and Baoshan Iron & Steel lost 5.85 per cent.

'The market has been rising very quickly and government officials don't want to see any market volatility during the big political meetings in March so they are acting now to cool things down,' Guotai Junan analyst Wu Jianxiong said.

'The securities regulator is increasing the supply of new shares into the market and has suspended the approval of new mutual funds. The intention to stabilise the market is very clear.'

In recent months, the China Securities Regulatory Commission has been telling companies they must have a good reason to sell shares in Hong Kong and that they should instead consider listing at home, according to foreign bankers in Beijing who have been offering these companies H-share underwriting services. The government has simplified the approval process for A-share listings, reducing the waiting period to 80 days.

The number of mainland stock trading accounts exceeded 80.5 million this week, with an average of 90,000 accounts being opened each day as investors flood back to a market that rose 130 per cent last year after four years of falling prices.

However, probably only 10 million of those accounts are actively traded by stock investors.

'The market is controlled by a few hundred thousand accounts held by large individual investors and corporations,' Mr Howie said. 'They're the ones borrowing from banks to invest in stocks.'