The benchmark S&P/ASX200 index dropped 142.8 points, or 1.65 per cent, to 8,497.8 on Thursday, while the All Ordinaries fell 157 points, or 1.77 per cent, to 8,690.7.
The losses left the S&P/ASX200 at its lowest level since November 21 and down 2.5 per cent since the start of the year.
Overnight Iran attacked the site of the world's largest LNG plant in Qatar, causing extensive damage in retaliation for an Israeli strike on its South Pars gas field.
In a social media post, US President Donald Trump threatened to "massively blow up" the entire South Pars gas field if Iran attacked Qatar again.
The threat alarmed local market analysts.
"If the targeting of energy infrastructure continues unchecked, it will most definitely push an already tricky global economic situation over the edge into a dire one," IG analyst Tony Sycamore said.
Brent crude jumped $US5 a barrel to a nine-day high of about $US111.
Meanwhile, the US Federal Reserve left interest rates on hold as expected, but comments following the meeting left traders wondering whether its next move might be to raise rates.
The US central bank had been flagging potential rate cuts this year but Fed chairman Jerome Powell told reporters fewer members of its rate-setting committee now favoured that, given the uncertainties stemming from the war.
Earlier this week, Australia's Reserve Bank hiked interest rates to 4.10 per cent, but seven other central banks meeting this week have either left rates on hold or are expected to do so.
Eight of the ASX's 11 sectors finished lower on Thursday and three closed higher, including energy, which gained 5.1 per cent.
The biggest loser was materials, which had dropped 4.8 per cent amid heavy losses for gold miners.
Given the prospect of US interest rates staying higher for longer, the yellow metal tumbled to a six-week low of $US4,849, from over $US5,000 an ounce on Wednesday.
Seventeen of the 20 worst-performing companies in the ASX200 were all goldminers, with Ora Banda falling the most, by 14.1 per cent.
Northern Star lost 9.5 per cent, Evolution fell 9.6 per cent and Westgold subtracted 12.8 per cent.
Elsewhere in the mining sector, Fortescue retreated 3.4 per cent to $19.04, BHP subtracted 3.5 per cent to $48.35 and Rio Tinto diminished 3.2 per cent to $151.35.
In t he financial sector, the big four banks mostly lost ground. NAB dropped 1.3 per cent to $46.62, Westpac fell 1.0 per cent to $41.13 and ANZ dipped 0.3 per cent to $37.02.
CBA was the outlier, up 0.2 per cent to $177.36.
In the energy sector, Woodside soared 7.2 per cent to a more than two-year high of $33.70, Santos added 3.2 per cent to $8.02 and Whitehaven Coal grew 2.3 per cent to $8.95.
Geelong refinery and Shell-branded petrol station owner owner Viva Energy Group was the biggest gainer in the ASX200, climbing 15.2 per cent to a one-year high of $2.43.
The Australian dollar was trading at 70.37 US cents, from 71.19 US cents late Wednesday afternoon.
ON THE ASX:
* The S&P/ASX200 dropped 142.8 points, or 1.65 per cent, to 8,497.8
* The broader All Ordinaries fell 157 points, or 1.77 per cent, to 8,690.7
One Australian dollar trades for:
* 70.37 US cents, from 71.19 US cents at 5pm AEDT on Wednesday
* 112.37 Japanese yen, from 112.97 Japanese yen
*61.37 euro cents, from 61.65 euro cents
* 53.04 British pence, from 53.24 British pence
* 121.01 NZ cents, from 121.31 NZ cents
17°C