Wall Street fell on Thursday after the European Central Bank dashed hopes that policy-makers were preparing a financial bazooka to contain the debt crisis, and Germany rejected some proposals to add power to the euro zone's bailout fund.

U.S. markets have been on edge all week in anticipation of a summit deal that would come to grips with the euro zone's growing debt crisis, and pave the way for greater action by the ECB to hold down bond yields.

But actions from Europe - both early and late in the day - were a stark disappointment.

Before the market's open, ECB President Mario Draghi discouraged expectations that the central bank would massively increase its purchases of government bonds after a crucial Brussels summit on Friday.

Shortly before the closing bell, Germany rejected some measures in draft conclusions from the summit, including giving the European Stability Mechanism (ESM) a banking license and issuing common euro-zone debt. U.S. stocks and the euro fell sharply following the news.

It looks like it's (the opposition) coming from Germany. That just spells more trouble ahead in the days to come, said Peter Cardillo, chief market economist at Rockwell Global Capital in New York.

More than 44,500 S&P E-Mini futures contracts traded between 3:40 p.m. and 3:45 p.m., when the Germany headline appeared. This was the busiest five minutes of the day, other than the last five minutes of trading, which typically has the highest volume.

The S&P financial sector index <.GSPF> was the biggest loser, falling 3.7 percent. That followed sharp losses in European banks' shares as sources told Reuters the European Banking Authority (EBA) sees the capital shortfall at European banks at 114.7 billion euros ($154 billion).

Shares of Morgan Stanley , a barometer of risk aversion due to its perceived exposure to Europe's crisis, fell 8.4 percent to $15.88.

The latest developments from Europe overshadowed a cut in the bloc's interest rate to a record low 1 percent and extra liquidity provisions for banks.

The Dow Jones industrial average <.DJI> tumbled 198.67 points, or 1.63 percent, to end at 11,997.70. The Standard & Poor's 500 Index <.SPX> fell 26.66 points, or 2.11 percent, to 1,234.35. The Nasdaq Composite Index <.IXIC> lost 52.83 points, or 1.99 percent, to close at 2,596.38.

The decline comes after three days of gains for U.S. stocks when the S&P 500 tried and failed to stay above its 200-day moving average, which has been a key level for investors to watch this year, and one that could prove tough to break.

But Thursday's pullback, concentrated in economically sensitive areas, was a far cry from the wild swings of recent months when uncertainty over Europe has dominated headlines. That is being seen as a sign of resilience by many investors who are hoping for seasonal strength into the end of the year.

Yields on European sovereign debt spiked. Ten-year Italian government bond yields rose 44 basis points to 6.51 percent -- the day's high. German Bund futures hit a session high of 136.89, up 109 ticks on the day.

Earlier, data showed U.S. jobless claims fell more than expected in the latest week, a sign the labor market recovery was gaining momentum. Claims slid to a nine-month low.

About 7.55 billion shares traded on the New York Stock Exchange, NYSE Amex and Nasdaq, slightly below the daily average of 7.95 billion.

Declining stocks outnumbered advancing ones on both the New York Stock Exchange and the Nasdaq by a ratio of slightly more than 6 to 1.

(Reporting By Angela Moon; Editing by; Jan Paschal)

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