* Financials drag market lower; volatility spikes
* U.S. manufacturing returns to growth in August
* Dow drops 1.6 pct, S&P off 1.7 pct, Nasdaq off 1.7 pct (Updates to early afternoon)
By Rodrigo Campos
NEW YORK, Sept 1 (Reuters) - Investors dumped U.S. stocks on Tuesday, spooked by uncertainty over the health of financial companies and concerns that the explosive rally since March may have run ahead of economic reality.
Benchmark indexes rose in late morning trading but sharply reversed course due to fears of a revival of trouble in the financial sector. The KBW bank index dropped 4 percent. Among the top drags were shares of JPMorgan Chase & Co, down 2.2 percent at $42.49, and Citigroup, down 5.8 percent at $4.71.
Positive manufacturing and housing data inspired only a brief rally, which investors used as an opportunity to sell.
The Institute for Supply Management showed U.S. manufacturing expanded in August for the first time since January 2008. The National Association of Realtors said pending home sales rose in July to the highest level since June 2007.
"Along with the good news, there were also some notes of caution," said Kim Caughey, senior equity research analyst at Fort Pitt Capital Group in Pittsburgh.
"The home tax credit initiative is coming to an end in November and I think the Realtors' association understands this is pulling forward sales and that demand (for homes) is going to dry up."
An $8,000 tax credit available for first-time home buyers expires before Dec. 1.
The Dow Jones industrial average dropped 153.94 points, or 1.62 percent, to 9,342.34. The Standard & Poor's 500 Index lost 17.61 points, or 1.73 percent, to 1,003.01. The Nasdaq Composite Index fell 33.87 points, or 1.69 percent, to 1,975.19.
Caughey said banks' assets are based on home prices and bets that housing prices could resume their fall may be hurting financial shares.
The CBOE Volatility Index or VIX, Wall Street's favorite barometer of investor fear, shot up 9.1 percent to 28.38 as investors use options to take out protection against further declines in stocks. (Editing by Jan Paschal)