The overnight search on the Tokyo startup company spooked investors who rushed to dump Livedoor shares and other internet-related issues, including Softbank Corp, Rakuten and Yahoo Japan on Tuesday.
But traders also said investors had been waiting for an excuse to sell stocks and lock in profits after the Tokyo Stock Exchange's extended rally.
Masayoshi Yano, senior market analyst at Tokai Tokyo Research Centre, said: "The Livedoor incident triggered this correction."
The Nikkei 225 index plunged 462.08 points, or 2.8%, to close at 15,805.95 points on Tuesday, marking the biggest single-day drop since 10 May 2004, when the index lost 554.12 points, or 4.8%.
Within an hour after trading began, Livedoor shares fell 14.4% or ¥100, its daily limit from the previous close, to ¥596 ($5.18).
The price was frozen there all day as sell orders of 255 million shares overwhelmed buy orders of just 2.9 million.
The Tokyo prosecutors' office, which raided Livedoor's offices on Monday evening, said the company was suspected of violating securities laws in spreading false information, but refused to elaborate.
Kyodo News agency reported that Value Click Japan Inc, the predecessor of a Livedoor subsidiary, carried out illegal stock swaps with Japanese publisher Money Life in 2004.
Prosecutors raiding Livedoor's
Roppongi Hills premises
Value Click, now Livedoor Marketing Co, also inflated profit figures in its financial statement released the next month to improperly raise its stock prices, Kyodo said.
Livedoor offers various internet services, including consulting, telecommunications, mobile sites and software development.
It also has also bought up chunks of other companies and managed to raise money by offering more of its own stock.
Chief denies wrongdoing
Takafumi Horie, the company's 33-year-old chief executive, - a celebrity in Japan for his bold buy-out attempts and frequent television appearances - denied any wrongdoing and said he would not change his expansionary business strategy, but worried investors still flooded the stock market with sell orders.
Speaking at an early morning news conference, Horie said Livedoor was conducting its own investigation into the matter.
"We are making our best effort internally to find out what has happened and we will disclose our findings to the public as soon as we find out," said an uncharacteristically sombre Horie, adding: "There are no problems with the business."
He added that Livedoor was "co-operating with prosecutors in their investigation".
Favouring T-shirts over business suits, Horie often appears on TV shows and runs a widely read blog. A dropout of the prestigious University of Tokyo, he shot to fame with the Japanese public in 2004 when he tried unsuccessfully to buy an ailing professional baseball team.
"There are no problems with the business"
Livedoor chief executive
He also made an unsuccessful hostile takeover bid for Fuji Television Network Inc and ran in parliamentary elections last year as an independent, supported by the ruling Liberal Democratic Party but did not get elected.
Taken down a notch
News of the raid made banner headlines in all of Japan's major newspapers on Tuesday, and TV talk shows also were abuzz
about the news.
The immediate public perception seemed to be that the authorities were attempting to clamp down on wayward entrepreneurs testing new territory in stock trading and acquisitions - but also that Horie might have crossed a
A Tokyo-based analyst who declined to be identified, explained: "One thing is for sure, the establishment has decided to take him down a notch.
"Even if nothing comes out of it, his whole strategy is M&A (mergers and acquisitions). If they're calling into question practices in the past, it might be harder to source deals in the future. Suddenly he's on the blacklist rather than the maverick in a good way."
The case also highlights the need for clearer regulations in such areas as Japan struggles to shift to a Western-style free market economy after decades of government protection.
Sadakazu Tanigaki, the finance minister, said if the reported allegations were true, the case showed a need for greater transparency in the Japanese market.
"They seem be a far cry from the transparency and fairness that Japan has been working hard to achieve," he told reporters.