"The CSRC is clearly sending a warning, especially to retail investors", said Kevin Leung, strategist with Haitong International Securities Group Ltd in Hong Kong.

Prior to Monday, the benchmark Shanghai index had been up 4.4 percent so far this month after finishing 2014 with a 53 percent surge.

Because 80 percent of the transactions in the A-share market are by retail investors, who have been piling up margin positions amid the rally, analysts said the authorities had been concerned that margin trading was leveraging the risks in the equity market.

Outstanding margin loans surged to 1.08 trillion yuan ($174 billion) as of Jan 13 from about 400 billion yuan at the end of June, according to Bloomberg.

"The CSRC's announcement regarding margin trading activity was a nasty shock. With less incremental liquidity flowing into stocks and dampened sentiment, the market will correct in the near term, and the move may be violent," Hong Hao, chief strategist with BOCOM International Holdings Co, wrote in a research note on Monday.

Profit-taking also drove down prices on Monday, said Leung.

CITIC Securities said in a filing to the exchange in Hong Kong on Friday that its biggest shareholder, CITIC Group Corp, had sold 348 million shares from Jan 13 to Jan 16, raising more than 11 billion yuan in cash.

The plunge on Monday does not signal an end to the A-share rally, analysts said.

"A correction will create another entry opportunity for those who have missed out," Hong said.

A private equity fund manager based in Shanghai agreed. "The recent rally in financial shares was overdone and the market will go through a technical correction. It will head for gains again within several days,"

Leung had a different take. "I personally cannot find any support in the fundamentals for the recent aggressive valuation pickup in bank and other financial shares," he said, adding the momentum for big-cap A shares was over, while H shares would have a bigger chance to pick up as they are trading at heavy discounts to A shares.

At a glance

Why did mainland stock markets fall on Monday?