Nikkei's Manufacturing Purchasing Managers' Index, compiled by Markit, fell to a 28-month low of 49.1 in December from November's 50.3.
It was also the first reading below the 50 threshold that separates growth from contraction since October 2013.
"India's manufacturing sector took a turn for the worse at the year-end, with already gloomy internal demand further hampered by floods in the south of the country," said Pollyanna De Lima, economist at Markit.
Severe rainfall and flooding caused widespread destruction in late November and early December, constraining output to its lowest since the global financial crisis.
The output sub-index fell to 46.8 from 50.4 the previous month, its lowest since early 2009, as new orders fell for the first time in more than two years.
Weak growth will likely harden expectations that the Reserve Bank of India will ease policy further by June, provided inflation is under control.
Inflation has remained within the RBI's January target range of 2-6 per cent, giving room for the central bank to shave 125 basis points from rates in 2015. After four moves, the benchmark rate currently sits at 6.75 per cent.
But the survey showed output prices continued to rise, driven by higher input costs.
© Thomson Reuters 2016