The Dow Jones Industrial Average fell 1.6 percent, the broad-based S&P 500 index 0.6 percent and the tech-heavy Nasdaq Composite Index 0.3 percent. This came after they had been even further in the red earlier.
US WTI oil rose just over 7 percent, trading above $80 a barrel for the first time since January last year - before falling slightly again to $79.90. North Sea oil (Brent) climbed about 4 percent to $84.70 a barrel.
Gas prices also rose sharply.
This followed Tehran's statement that an Iranian missile set an American oil tanker on fire in the Persian Gulf, and Tehran's continued strong rhetoric in the war against Israel and the United States.
It also raised questions about President Donald Trump's Tuesday promises regarding military escorts and insurance solutions to maintain shipping through the Persian Gulf and the Strait of Hormuz, where just over a fifth of the world's oil passes.
Sam Stovall, chief strategist at the analysis firm CFRA Research, tells CNBC that investors are now wondering whether the US has bitten off more than it can chew.
Can Trump really escort all ships through the Strait of Hormuz?
What kind of responsibility can we place on ourselves, and how would that affect our debt levels? Investors are basically saying that whatever is happening now is not good.
Earlier in the day, energy prices also knocked the air out of stock markets around Europe.
