The closely-watched Markit Flash UK Composite Output Index plummeted to its lowest level since April 2009, falling to 47.7 in July, compared to 52.4 in June.
A reading above 50 indicates growth.
Chancellor Philip Hammond said tax and spending policy could be “reset” if the economy takes a downturn.
The Chancellor said he was ready to use the Autumn Statement mini-Budget to set the economy on a different course if analysis shows the Brexit vote has had an impact.
Mr Hammond, who is visiting China, said: “Over the medium term we will have the opportunity with our Autumn Statements, our regular late-year fiscal event, to reset fiscal policy if we deem it necessary to do so in light of the data that will emerge over the coming months showing us exactly what is happening in the economy post the referendum decision.”
The sharp contraction was triggered by falling output and orders for the first time since the end of 2012, while business optimism in Britain’s powerhouse services sector hit a seven-and-a-half-year low.
The data, collected between July 12 and 21, provides a stark picture of the state of the economy following the Brexit vote, with City experts now warning that Britain could be heading for a recession.
Sterling was down 0.2% against the dollar at 1.318 US dollars after the report was published, while the pound also fell 0.3% against the euro at 1.195 euro.
Chris Williamson, chief economist at Markit, said the update showed a “dramatic deterioration” in the UK economy and expects gross domestic product (GDP) to contract by 0.4% in the third quarter.
“The downturn, whether manifesting itself in order book cancellations, a lack of new orders or the postponement or halting of projects, was most commonly attributed in one way or another to Brexit.”
He added: “Given the record slump in service sector business expectations, the suggestion is that there is further pain to come in the short term at least.”
The study found that its flash UK services PMI (purchasing managers’ index) hit an 88-month low of 47.4 this month, compared to 52.3 in June.
The flash UK manufacturing PMI was also in the doldrums, slipping to a 41-month low of 49.1 in July, after a reading of 52.1 the month before.
The flash UK manufacturing PMI output index also dropped from 52.9 to 49.1 over the period.
The report said the downturn in the services sector was “more marked” than in manufacturing, with services activity and new orders dropping at their quickest rate for seven years.
But while output and new orders also came under pressure in the manufacturing sector, its new export business rose for the second straight month, boosted in part by the sharp drop in sterling following the Brexit vote.
The update comes after the Bank of England said on Wednesday that business uncertainty had ‘’risen markedly’’ since the referendum result - but there was ‘’no clear evidence’’ of a sharp economic slowdown.
However, Neil Wilson, markets analyst at ETX Capital, said the flash PMI data showed that Britain should be bracing itself for another recession, while the Bank of England should move to cut interest rates in August.
“The readings suggest we are heading for a recession again and it is almost certain the Bank of England will pull the trigger on aggressive stimulus to boost aggregate demand.
He added: “The Bank will throw the kitchen sink at this now.”
Samuel Tombs, chief UK economist at Pantheon Macroeconomics, said: “The collapse in the composite PMI to its lowest level since April 2009 provides the first major evidence that the UK is entering a sharp downturn.”
He added: “The chart shows that the composite PMI has fallen to a level that has persuaded the (Bank’s) Monetary Policy Committee (MPC) to cut interest rates by about 50 basis points in the past.”