The S&P/TSX composite index fell 94.14 points to 12,658.09, while the Canadian dollar rose 0.73 of a cent to 97.14 cents US.
On Wall Street, the Dow Jones industrials fell 12.67 points to 15,269.93, the S&P 500 was down 4.84 points at 1,650.51 and the Nasdaq dipped 3.88 points to 3,459.42.
The 7.3 per cent slide in the Nikkei to 14,483.93, which was also partly blamed on a spike in Japanese government bond yields, amounted to the biggest drop for the index since Japan was hit by a devastating earthquake and tsunami more than two years ago.
The Nikkei has been the best-performing major index this year, having risen around 45 per cent to five-year highs before Thursday's drop. The index has been buoyed by the announcement of aggressive monetary stimulus by the Bank of Japan, which has piled pressure on the yen.
The drop could be seen as a sign that investors are getting nervous that Japan's plan to try to end two decades of stagnation may not be working, said John Tsagarelis, a portfolio manager at Manulife Asset Management.
"We've had a tremendous rally not so much on fundamentals but on expectations," he said. "I think we'll probably be taking breathers over the next couple of weeks because the markets have moved so aggressively, especially in Japan."
The weakness in markets could also be fallout from mixed messages from U.S. Federal Reserve chairman Ben Bernanke on Wednesday.
Bernanke told the U.S. Congress that the Fed has no plans to end its $85-billion a month in bond purchases. But, when pressed, he said the Fed would consider stopping the program as early as Labour Day if the economy shows significant signs of improvement.
Minutes of the Fed's April 30-May 1 monetary meeting, released following Bernanke's speech, showed that some officials had considered slowing the asset purchases as early as June.
Tsagarelis said investors had been predicting that quantitative easing would continue until at least January or February 2014.
Either way, it was no surprise that the stimulus will eventually run out.
"The math must lead them (the Fed) to consider removing quantitative easing sooner rather than later because they are just owning too much of the bond market, the treasury market and the MBS (mortgage-backed security) market in the United States," he said.
Much of the recovery in global stock markets over the past few years has had its roots on the extra liquidity that has flowed into financial markets as a number of central banks, particularly the Fed, have pursued stimulus programs.
Meanwhile, weaker-than-expected Chinese manufacturing data also resulted in concerns in the markets over the outlook for commodities.
The July crude contract was down three cents to US$94.25 a barrel and the energy sector dropped 0.59 per cent. July copper fell eight cents to US$3.30 a pound, with the metals and mining sector leading decliners on the TSX with a drop of 2.89 per cent.
Gold was the only advancer on the index, with an uptick of 0.42 per cent. June bullion surged $24.30 to US$1,391.70 an ounce.
The markets had been much lower earlier in the day, but clawed back some of the losses amid a 17 per cent, or US$3.63, boost in the shares of Hewlett-Packard (NYSE:HPQ) after the world's largest personal computer maker released a positive outlook. Its shares closed at $24.86.
The indexes were also helped by the release of encouraging unemployment benefits data in Canada and the United States.
Statistics Canada said the number of people receiving regular employment insurance benefits declined by one per cent to 523,700 in March. The number of beneficiaries was down 8.1 per cent compared with a year earlier.
In the U.S., unemployment benefits applications fell by 23,000 last week, while unemployment aid declined to a seasonally adjusted 340,000 in the week ended May 18. That's down from 363,000 the previous week.
The U.S. housing market also showed signs of improvement.
Sales of new homes rose in April to the second highest level since the summer of 2008 while the median price for a new home hit a record high. New home sales rose to a seasonally adjusted annual rate of 454,000 in April, up 2.3 per cent from March and just slightly below January's 458,000. Both January and April had the highest sales rates since July 2008.
In corporate news, TD Bank (TSX:TD), the first of Canada's major banks to report its latest quarterly earnings, said profits were up two per cent from a year ago at $1.723 billion or $1.78 per share while adjusted earnings were $1.8 billion or $1.90 per common share.
While the adjusted earnings were up six per cent from a year ago, they were just short of the $1.91 per share consensus estimate of analysts compiled by Thomson Reuters. The bank's shares dropped 0.46 per cent, or 39 cents, to $83.65.
Meanwhile, debtholders of struggling wireless carrier Mobilicity approved a plan to sell the company to Telus for $380 million, the first of several hurdles the deal faces before it can close. If the acquisition is approved, there will be continuing service for Mobilicity's 250,000 cellphone customers and jobs for its 150 employees. Shares in Telus (TSX:T) were down 1.09 per cent, or 41 cents, to $37.28.