Two people -- a male student and a female crew member -- were confirmed dead as the vessel sank 20 kilometres (13 miles) off the southern island of Byungpoong.
The government retracted an earlier announcement that 368 people had been rescued, and said it could only confirm that 164 people had been brought to safety.
"The remaining 293 are unaccounted for," Lee Gyeong-Og, the vice minister of security and public administration, told a press briefing in Seoul.
The revision raised concerns that the final death toll could be far higher than originally feared, after the 6,825-tonne ship listed sharply, capsized and finally sank all within two hours of sending a distress signal at 9:00am (0000 GMT).
Dramatic television aerial footage showed terrified passengers wearing life jackets clambering into inflatable boats as water lapped over the rails of the vessel as it sank.
Some could be seen sliding down the steeply inclined side of the ferry and into the water, as rescuers, including the crew of what appeared to be a small fishing boat, struggled to pull them to safety.
Lee said the inflated figure for the number of rescued had resulted from confused information arriving from multiple sources.
Of the 429 passengers on board the ferry which had been bound for the popular southern resort island of Jeju, more than 300 were students travelling with 14 teachers from a high school in Ansan just south of Seoul.
Many of those saved appeared to have been rescued by fishing and other commercial vessels who were first on the scene before a flotilla of coastguard and navy ships arrived, backed by helicopters.
- Visibility 'very low' -
Lee said divers, including a team of South Korean navy SEALS, were searching the submerged vessel.
"There is so much mud in the sea water and the visibility is very low," he added.
The US 7th Fleet said an amphibious assault ship, the USS Bonhomme Richard which was on routine patrol west of the Korean peninsula, was being sent to help.
The ferry had sailed out of the western port of Incheon on Tuesday evening.
The cause of the accident was not immediately clear, although rescued passengers reported the ferry coming to a sudden, shuddering halt -- indicating it may have run aground.
The weather was described as "fine" with moderate winds and sea swell.
"There was a really loud noise and then the boat immediately began to shift to one side," said one rescued adult passenger, Kim Song-Muk.
"People were scrambling to get to the upper decks, but it was difficult with the deck slanted over," Kim told the YTN news channel.
One local official, who had taken a boat to the site and arrived an hour after the distress signal was sent, said he was "very concerned" about those still missing.
"The ship was already almost totally submerged when I got there. A lot of people must have been trapped," the official, who declined to be identified, told AFP by phone.
The water temperature was cold at around 12.6 degrees Celsius (55 Fahrenheit).
- 'A big thumping sound' -
"I heard a big thumping sound and the boat suddenly started to tilt," one rescued student told YTN by telephone.
"Some of my friends fell over hard and started bleeding. We jumped into the water and got picked up by the rescue boats," he said.
Distraught parents of the students gathered at the high school in Ansan, desperate for news.
There were chaotic scenes in the school's auditorium, with parents yelling at school officials and frantically trying to make phone calls to their children.
"I talked to my daughter. She said she had been rescued along with 10 other students," one mother told the YTN news channel.
"They said they had jumped into the water before getting rescued," she said.
Scores of ferries ply the waters between the South Korean mainland and its multiple offshore islands every day, and accidents are relatively rare.
However in one of the worst incidents, nearly 300 people died when a ferry capsized off the west coast in October 1993.