The prospect of a multibillion-euro bailout for Spain increased today as the country's borrowing costs edged up on fears over its beleaguered banking sector.
The yield on Spanish 10-year bonds rose to 6.6% - close to levels which pushed Greece, Portugal and Ireland into taking financial support from the EU.
Spain's woes snowballed as a plan to shore up the finances of its troubled lender Bankia by indirectly tapping the continent's central bank for support was rejected.
Plans to shore up the finances of lender Bankia were rejected
The escalating eurozone crisis spooked investors as London's FTSE 100 Index lost nearly 2% of its value, while Germany's Dax and France's Cac-40 nearly lost 2% apiece.
Chris Beauchamp, market analyst at IG Index, said: "Without wishing to sound apocalyptic, it does feel as if Spain is gradually shuffling towards the abyss."
As Spain's borrowing costs increased, the UK saw interest rates fall to record lows, with the yield on 10-year bonds sinking to 1.67%, reflecting the confidence investors have in Britain's ability to cope with its debts.
Chancellor George Osborne is likely to view the figures as evidence that his deficit-busting austerity measures are protecting the UK's position as a financial safe haven.
But there was a mixed picture for the UK as a European Commission (EC) report warned high house prices and mortgage debt were damaging the economy, while an EC survey revealed a plunge in confidence among businesses in May.
Banking shares were among the biggest losers in London with Lloyds Banking Group dropping nearly 2%, Royal Bank of Scotland sliding 3% and Barclays shedding nearly 1%.
Bankia, which was bailed out last month when the government converted loans into a 45% stake, may need more cash than previously estimated to keep it afloat.
The Spanish government last weekend proposed a way of injecting 19bn euro (£15bn) into the lender by indirectly using the European Central Bank (ECB), a plan the ECB later warned could be illegal.
The warning came as three unlisted Spanish savings banks, Liberbank, Ibercaja and Caja 3, said they would merge as they struggled with billions of euro of bad property debt.
The deepening problems in Spain prompted speculation that the country would have to turn to the ECB for a bailout.
Meanwhile, Italy's funding costs rose sharply at a bond sale, with its own 10-year yields topping 6% for the first time this year, although demand was healthy.
And the problems in Greece remained a threat as it awaits another election on June 17, which could see the country reject or accept harsh austerity measures, and could ultimately influence its future membership of the single currency.
But as the eurozone crisis deepens, the perceived health of the UK's finances improves.
The Chancellor has stuck by his tough austerity plans despite the UK economy returning to recession in the first three months of 2012.
Osborne also faced warnings from the International Monetary Fund that the UK may have to alter its fiscal targets in the face of significant financial shocks, such as a Greek exit from the euro.
Shadow chancellor Ed Balls said the IMF's report amounted to an endorsement of Labour calls for a Plan B to boost jobs and growth.