China's rate rise, its first since 2007, is aimed at curbing inflation and raised concerns about demand growth for commodities and strengthened the dollar.
"This dollar-driven move has pulled down prices across the board in the oil markets," said Tom Knight, a trader at Truman Arnold in Texarkana, Texas.
U.S. crude for November delivery fell $3.59, or 4.32 percent, to settle at $79.49 per barrel, the biggest one-day percentage dive since early February.
A day ahead of the U.S. November contract's expiration and before release of U.S. oil inventory reports expected to show stockpiles rose last week, U.S. December crude also dropped more than 4 percent, settling at $80.16 a barrel.
Crude oil trading volume was near 790,000 lots on Tuesday afternoon, just above the 30-day average of 768,063 lots, according to Reuters data.
In London, ICE Brent December crude fell $3.27, or 3.88 percent, to settle at $81.10 a barrel.
The specter of China's dynamic economic growth slowing pressured oil and other commodity prices and sent investors to the safe-haven dollar to cut risk exposure. The dollar index DXY was on track for its biggest daily rise in two months and its inverse correlation to oil prices rose to the highest in about a month.
The dollar had already received lift late on Monday from comments by U.S. Treasury Secretary Tim Geithner that the United States would not engage in competitive currency devaluation.
A stronger dollar can pressure oil prices by making dollar-denominated oil more expensive to users of other currencies and by pulling investment into foreign exchange markets from commodities that are viewed as riskier bets.
"(The Chinese rate move) could imply a little bit of softer growth in commodities demand," said UniCredit's Jochen Hitzfeld.
Copper retreated from 27-month highs on top metals consumer China's interest rate hike. Gold also fell as investors reacted to the stronger dollar.
Economic concerns sent U.S. equities lower on Tuesday, as consumer-sensitive Apple and IBM fell after their results disappointed investors.
"(Crude) could rebound and make this up tomorrow for no apparent reason. The fact that the market looks elsewhere and not fundamentals shows that the premium associated with exogenous elements will wax and wane and volatility will stay with us," said Mike Fitzpatrick, vice president at MF Global in New York.
U.S. OIL INVENTORIES
Investors focusing on fundamentals got a snapshot of U.S. inventories when the industry group the American Petroleum Institute released data late Tuesday showing crude stocks rose 2.3 million barrels last week.
Crude futures prices extended losses slightly after the report in post-settlement trading.
The API report showed gasoline stocks fell only 83,000 barrels and distillate inventories fell only 854,000 barrels, both less than analyst expectations.
Ahead of the report, a Reuters analyst survey yielded a forecast for crude stocks to be up 1.9 million barrels, with gasoline stocks expected to be down 1.3 million barrels and distillates down 800,000 barrels.
The more closely watched oil inventory report from the U.S. Energy Information Administration is set for release at 10:30 a.m. EDT on Wednesday.
Another measure of fundamentals was mixed on Tuesday, as MasterCard reported U.S. retail gasoline demand rose 2.7 percent last week from the prior week, but dipped 0.9 percent from the year-ago period and was lower on a four-week average than the same period in 2009.
Energy investors continued to gauge the impact of the strike at France's Fos-Lavera oil port that has shut refineries and forced the French government to tap emergency fuel reserves.
