The CSI300 index <.CSI300> and the Shanghai Composite Index <.SSEC> both slumped in late afternoon trade, ending down and 6.5 pct, respectively.

The Shanghai Stock Exchange saw A share turnover hit 1.2 trillion yuan ($193.57 billion), an all time record high, on the selloff.

In Hong Kong, the Hang Seng Index <.HSI> closed 2.2 percent down, and the China Enterprises Index <.HSCE> lost 3.5 percent.

China's stock market has surged over 140 percent over the past 12 months despite a flagging economy, as retail investors, including university students, barbers and janitors piled into the world's best performing market, though economists have warned that, based on economic fundamentals, the rally was unjustified.

Official data shows the surge has been accelerated by cheap credit provided to retail investors by brokerages, banks and other channels, with the outstanding value of margin finance hitting a record 2 trillion yuan on Tuesday.

On Thursday morning at least three Chinese brokerages, including Guosen Securities Co (>> Guosen Securities Co Ltd), Southwest Securities Co (>> Chongqing Changjiang River Water Transpt) and Changjiang Securities Co (>> Changjiang Securities Company Limited) said they would tighten margin requirements.

"The brokerages are front running what the regulator wants to do," said Bernard Aw, an analyst at ING Markets in Singapore.

Haitong Securities (>> HAITONG Securities Company Limited) and GF Securities (>> GF Securities Co Ltd) had made similar moves earlier in the week.

"This is no longer an individual case, but an industry-wide campaign," said Zhang Chen, analyst at Shanghai-based hedge fund Hongyi Investment. "Clearly, they got guidance from regulators, and this shows a change of government's attitude toward the margin trading business."

LIQUIDITY DRAIN PLAYS ON NERVES

Key mainland sub indexes including property <.SSEP>, energy <.CSI300EN> and financial services <.CSI300FS> plunged more sharply, with both energy and property slumping over 7 percent.

Shares in several Chinese brokers fell by between 6-8 percent.

Tian Weidong, analyst at Kaiyuan Securities in Xi'an, said that the sharp drop in financials was partly due to news that Central Huijin Holdings, an asset management company controlled by Beijing, had reduced its holdings in major state-owned banks China Construction Bank (>> China Construction Bank Corporation) and ICBC (>> Industrial and Coml Bank of China Ltd), both of which are index heavyweights.

The news was published on Wednesday by the Hong Kong Stock Exchange in a daily disclosure report.

But he added that many investors were already looking for a reason to sell, and the changes to margin financing sparked the stampede.

"Many investors have become very cautious and are looking for a reason to take the profits they have already earned," he said.

The central bank's move to mop up excess liquidity in the interbank market was a contributory factor in the sell off.

While there was no information on how much money was drained, and money traders warned the adjustment could be minor, any suggestion of a squeeze was seen as negative for stocks.

Analysts warned of the risk of volatility intensifying.

"If the stock market suddenly reverses and investors default on their margin debts, the contagion effect will be much greater than in previous cycles, since the banking system is now more exposed to the brokerage industry," wrote Chen Long of Gavekal Dragonomics in a research note.

($1 = 6.1994 Chinese yuan renminbi)

(Additional reporting by the Shanghai Newsroom, Nate Taplin, and Nichola Saminather in SINGAPORE; Editing by Simon Cameron-Moore)

By Pete Sweeney and Samuel Shen