* Financials drag market lower; volatility spikes
* U.S. manufacturing returns to growth in August
* Dow drops 1.8 pct, S&P off 1.8 pct, Nasdaq off 1.6 pct (Updates to midday)
By Rodrigo Campos
NEW YORK, Sept 1 (Reuters) - U.S. stocks sank on Tuesday on increasing worries that there could be more bank failures and concerns that equity prices may have run ahead of the economic recovery.
A sharp drop in bank stocks in late morning trading pulled the Dow average and the broad Standard & Poor's 500 down almost 2 percent, with investors fearing a revival of balance-sheet trouble in the financial sector.
"The chatter from (some) hedge funds is that there is a bank default", said Jon Najarian, a founder of Web information site optionmonster.com.
The KBW bank index slumped 3.8 percent, with shares of Citigroup, down 7.2 percent at $4.64, among the top drags.
Stocks had been up earlier after data from the Institute for Supply Management showed U.S. manufacturing expanded in August for the first time since January 2008.
The Dow Jones industrial average slid 170.19 points, or 1.79 percent, to 9,326.09. The Standard & Poor's 500 Index dropped 18.44 points, or 1.81 percent, to 1,002.18. The Nasdaq Composite Index fell 33.12 points, or 1.64 percent, to 1,975.94.
The CBOE Volatility Index or VIX, which is Wall Street's favorite barometer of investor fear, shot up 8.2 percent to 28.15. (Additional reporting by Doris Frankel; Editing by Jan Paschal)