Cairn has been barred from selling the remaining 10.3% stake it holds in Cairn India which it had planned to offload as it embarks on a $400m (£242m) exploration drive in 2014.
The company, founded by ex-Scotland rugby player Sir Bill Gammell, made its name with a series of bumper finds in Rajasthan from the late 1990s, which funded payouts to investors worth around £2.2 billion in 2011.
Cairn said: "Cairn has been contacted by the Income Tax Department of India to discuss income tax assessments for the year ending 31 March 2007.
"Cairn is co-operating to provide the necessary documentation and information as requested.
"While discussions are ongoing, the Income Tax Department has instructed Cairn Energy PLC to hold its shares in Cairn India. Cairn will update the market in due course."
Its shares closed down 14.6p or 5.6% at 247.5p, reducing its market worth from £1.56bn to £1.47bn.
Analysts at Morgan Stanley cut their price target on the stock to 350p from 375p while maintaining an "overweight" rating.
The probe makes Cairn just the latest UK company to become embroiled in an Indian tax crackdown, with Vodafone and Royal Dutch Shell also facing investigations.
The dating of the accounts under scrutiny suggests that the Indian authorities are interested and want to investigate the initial public offering of Cairn India in 2007, after which Cairn retained a 69.5% holding.
The £980m of proceeds allowed the company to pay out a £3-per-share special dividend.
A later sale in 2011 gave mining company Vedanta a controlling stake, and allowed Cairn to make a £1.60 a share pay-out.
There are worries that Cairn could end up with a large bill but also that the case could take years to resolve.
Cairn had expected to raise $950m from selling its residual stake in Cairn India.
Earlier this week Cairn, now headed by chief executive Simon Thomson, set out plans to drill nine oil and gas exploration wells in 2014.