The weaker-than-expected survey knocked the country's main share index and other Asian markets off early highs, and lopped around a quarter of a U.S. cent from the Australian dollar, which is often used as a proxy for Chinese risk.
The flash Markit/HSBC Purchasing Managers' Index (PMI) fell to an eight-month low of 48.1 in March from February's final reading of 48.5. The index has been below the 50 level since January, indicating a contraction in the sector this year.
Output and new orders both weakened but new export orders grew for the first time in four months, the survey showed, suggesting the slowdown has been driven primarily by weak domestic demand.
"Usually, for the month of March, the PMI will rebound, because after Chinese New Year, there should be some activity coming back, but this PMI is disappointing," said Wei Yao, China economist at Societe Generale in Hong Kong. "The government probably will have to provide some supporting measures."
"I think the slowdown is not over yet and our expectation is that the deceleration will continue into Q2," she added.
The CSI300 index of the leading Shanghai and Shenzhen A-share listings shed all its gains after the data, before recovering some ground, while Hong Kong shares pared early gains of more than 1.5 percent.
The Markit/HSBC PMI is weighted more towards smaller and private companies than the official index, which contains more large and state-owned firms and has showed slight but slowing growth in the first two months of this year.
Both the final Markit/HSBC manufacturing PMI and the official manufacturing PMI for March are due on April 1.
A string of weak economic indicators in China this year has reinforced concerns about a slowdown.
"We expect Beijing to launch a series of policy measures to stabilize growth. Likely options include lowering entry barriers for private investment, targeted spending on subways, air-cleaning and public housing, and guiding lending rates lower," said Hongbin Qu, chief China economist at HSBC, in a note accompanying the PMI data.
Earlier this month, sources told Reuters the central bank was prepared to loosen monetary policy in order to keep the economy growing at 7.5 percent. Last year, China's economy grew 7.7 percent, the same pace as in 2012.
And Premier Li Keqiang said last week investment and construction plans would be accelerated to ensure domestic demand expands at a stable rate.
Zhiwei Zhang, chief China economist at Nomura in Hong Kong, expects the central bank to cut its reserve requirement ratio in the second quarter and third quarter, which would free up funds for banks to lend, and perhaps adopt expansionary fiscal policy in order to keep growth from dropping below 7 percent.
Finance Minister Lou Jiwei has said a healthy labor market was more important than reaching the government's 2014 growth target of about 7.5 percent.
The Markit/HSBC PMI showed a substantial increase in the employment sub-index, though the number remained below 50. It is
one of the few indicators to measure the health of China's labor market, an area of priority for Beijing as it sees low unemployment as a means to maintain social stability.
"We don't expect a significant stimulus response from the authorities. The labor market, now policymakers' primary concern, remains healthy," Julian Evans-Pritchard, Asia Economist at Capital Economics in Singapore, said in a note.
The government wants to reduce the economy's dependence on exports and enhance the role of consumption but it is unclear how much growth it might be willing to sacrifice to achieve that goal.
Last week, the yuan fell to 13-month lows, which traders and analysts attributed in part to attempts by the central bank to curb betting on its appreciation. A weaker yuan could help exports, which stumbled in February.
(Additional Reporting by Wang Lan; Editing by John Mair)
By Adam Rose