The Dow Jones Industrial Average dropped 182 points, or 1.4%, to 13,368. All of the Dow's 30 components were in negative territory.
Among the biggest decliners was Citigroup , whose shares fell 3% to $29.57.
The S&P 500 Index dropped 20 points, or 1.4%, to 1,477 and the Nasdaq Composite fell 47 points, or 1.7%, to 2,677.
"My guess is we've got some trying times ahead," said Phil Dow, the director of equity strategy for RBC Dain Rauscher. Bhutto's assassination is one factor.
"The geopolitical risk and uncertainty always plays a role, and my guess is this is part of the reason the market's down today," Dow said. "Also, you've got people beginning to worry about the relatively high earnings expectations next year, and then how financial stocks do when they report earnings in early to mid-January."
Pakistani opposition leader Bhutto was killed following a suicide bombing that also killed at least 20 others who attended a political rally in Rawalpindi, Pakistan.
The decline in stocks "has a lot to do with the assassination in Pakistan," said Marc Pado, U.S. market strategist at Cantor Fitzgerald. "It's destabilization in a region with a country the United States is semi-friendly with. We consider them on our side."
"The markets are thin. It doesn't take much news -- good or bad -- to move the market," Pado said. "The reaction is in oil pushing back toward $100."
Crude-oil futures surged 65 cents to $96.62 a barrel on the news of Bhutto's death, as energy traders worried about increased tensions in the Middle East.
Bhutto's assassination will also likely rattle Pakistan's equity markets.
On the New York Stock Exchange, more than 711 million shares exchanged hands, with decliners outpacing advancers 23 to 8. On the Nasdaq, more than 1 billion shares were traded, with decliners outpacing advancers 3 to 1.
On Wednesday, U.S. stocks finished with mild gains amid concerns over holiday retail sales and downbeat housing data. The Dow industrials rose 2 points, the Nasdaq Composite rose 10 points and the S&P 500 added a point.
Shares of Citigroup fell 2.6% after Goldman Sachs analysts said the financial-services giant may be forced to cuts its dividend by 40% due to write-downs now estimated at $18.7 billion in the fourth quarter.
Goldman is also forecasting write-offs pegged at $11.5 billion for Merrill Lynch & Co. and $3.4 billion for J.P. Morgan . Shares of the other two banks also declined.
Fitch Ratings put 205 residential mortgage-backed securities backed by bond insurers including MBIA Inc. and Ambac Financial under review for downgrades.
SLM Corp. , parent of student-loan giant Sallie Mae, tumbled 6.2%. Late Wednesday, the company said it would raise $2.5 billion through offerings of common and preferred stocks.
Of other stocks in focus, Apple gained 1.3% at $201.46 after the Financial Times reported that the 20th Century Fox unit of News Corp. has reached a deal to allow consumers to rent the studio's recent releases through Internet downloads. News Corp. also owns MarketWatch, the publisher of this report.
Disappointing economic data also added to the negative tone.
Excluding transportation orders, durable goods orders fell by 0.7% in November, the Commerce Department reported. Economists surveyed by MarketWatch were expecting orders for durable goods to climb by 2.9% in November after falling by 0.2% in October.
Separately, seasonally adjusted first-time jobless claims nudged up in the most recent weekly data, while continuing claims reached the highest level in more than two years, government data showed.
U.S. consumer confidence rose in December due to an increase in short-term expectations, though consumers "remain far from optimistic," the Conference Board reported Thursday.
The consumer confidence index rose to 88.6 from a revised reading of 87.8 in November. The initial estimate for November was 87.3.
Gold futures rose for a fourth day to end at $831.80 an ounce, as news of Bhutto's death heightened the metal's appeal as a safe-haven investment. A sliding dollar also put upward pressures on the precious metal.
U.S. Treasury bonds rallied Thursday, sending yields lower, as investors fled to the safety of fixed income assets.
The dollar was lower Thursday, as the euro rallied following reports of Bhutto's death as well as disappointing U.S. durable goods orders and weekly jobless claims data.
By Polya Lesova