* China factory activity shrinks at fastest pace in 3 years
* Dollar skids, S&P 500 falls 2 pct
* Crude oil futures drop (Updates with European stocks closing lower, VIX index levels)
By Caroline Valetkevitch
NEW YORK, Sept 1 (Reuters) - World stock indexes and commodities dropped on Tuesday as weak Chinese data revived fears about the effect of China's economic health on the global economy and fueled more market turmoil.
Oil prices fell more than 7 percent on concerns about global demand for petroleum, reversing a three-day rally that had pushed U.S. crude up 27.5 percent.
All three major U.S. stock indexes were down more than 2 percent, led by declines in energy shares, and were in negative territory for the year. The S&P 500 is now down 6.6 percent for the year so far.
The CBOE Volatility index, known as Wall Street's "fear gauge," was up 10.4 percent at 31.41, above its long-term average of 20. The index had spiked to 53.29 last Monday.
The moves followed a stormy week in the markets, when investors became increasingly concerned about further losses due to slowing growth in China.
The selloff in equities last week raised doubts about earnings and growth while fueling worries about whether central bank support could make a difference after years of loose policy around the globe.
On Tuesday, surveys showed China's manufacturing sector shrinking at its fastest pace in three years while its services sector also cooled.
Adding to economic worries, data showed U.S. factory activity hit a more than two-year low in August.
"The volatility is here to stay for a while or at least till the Fed gives us an indication regarding a rate increase," said Art Hogan, chief market strategist at Wunderlich Securities in New York.
Comments by Federal Reserve Vice Chairman Stanley Fischer over the weekend appeared to keep alive chances of a U.S. interest rate increase in September.
The Dow Jones industrial average fell 406.88 points, or 2.46 percent, to16,121.15, the S&P 500 lost 48.73 points, or 2.47 percent, to 1,923.45 and the Nasdaq Composite dropped 105.37 points, or 2.21 percent, to 4,671.14.
MSCI's all-country stock index fell 2.4 percent and is down 7.1 percent for the year to date. The pan-European FTSEurofirst 300 stocks index closed down 2.8 percent.
Asian stocks, particularly in Japan, fell overnight.
In the oil market, Brent crude dropped $3.24 to $50.91 a barrel. U.S. crude was down $3.10 at $46.10 a barrel.
While shares and commodities remained the focus, the mood was similarly wary in the currency and bond markets.
U.S. short- and medium-term Treasuries prices rose, with benchmark 10-year yields hitting a session low of 2.15 percent after reaching a 1-1/2-week high of 2.22 percent on Monday. The 10-year note was last up 6/32 in price.
The dollar sagged against the safe-haven yen and low-yielding euro as the Chinese data drove investors to unwind bets against the two currencies widely used to fund positions in riskier assets.
The dollar fell more than 1 percent to 119.9 yen, while the euro rose 1 percent to $1.1332.
Russia's ruble was among the hardest-hit emerging market currency as the price of oil fell.
The head of the International Monetary Fund, Christine Lagarde, summed up the global outlook in a speech in Indonesia, where she said global economic growth was now likely to be weaker than had been expected just a few months ago.
She cited a slower recovery in major advanced economies and a further slowdown in emerging nations and highlighted the need to "be vigilant for spillovers" from China's stutters.
Spot gold rose to a session high of $1,147.16 an ounce and was up 0.9 percent at $1,144.42 an ounce.
London Metal Exchange copper fell almost 1 percent to $5,087.50 as markets reopened after a long holiday weekend. Nickel slid 2 percent and aluminum skidded as well. (Additional reporting by Tanya Agrawal, Marc Jones, Lisa Twaronite in Tokyo; Editing by Dan Grebler and Meredith Mazzilli)