Hopes for a coordinated stimulus package and rate cuts to revive Asia's third-largest economy underpinned the market, though worries remained about dismal corporate earnings caused by a global economic downturn and financial market turmoil. "A good start to a year is always encouraging and it seems the rally has some more steam left," said Gajendra Nagpal, CEO of Unicon Financial. "In the short term, however, we will see a serious fall if the results disappoint a lot."

Shares in construction play Larsen & Toubro led the gains, rising 6.1 per cent to 821.75 rupees on hopes a stimulus package will help increase spending on infrastructure building, traders said.

ICICI Bank rose 3.5 per cent to 464.05 rupees after the No. 2 lender cut its main lending rates by 50 basis points on Wednesday, joining other lenders that have lowered rates to revive growth.

The stock had fallen about 64 per cent in 2008, caught in the financial market tailspin and slowing credit demand.

The main 30-share BSE index rose 2.66 per cent, or 256.15 points, to 9,903.46, its best close in more than a week.

It opened up 0.75 per cent and rose as much as 2.8 per cent during trade. All but two of its components gained ground.

The benchmark plunged 52.4 per cent in 2008, its biggest annual drop, and the outlook for 2009 was muddled by uncertainties with corporate earnings set to slow sharply.

"Although the quarterly corporate results this month are a big concern at this point in time, an economic stimulus package or big interest rate cut will help the sentiment in the near term," said Arun Kejriwal, strategist at research firm KRIS.

Expectations for monetary easing rose after data on Thursday showed inflation fell to a near 10-month low of 6.38 per cent in the third week of December, helped by lower prices of minerals and aviation fuel.

The benchmark 10-year bond yield, which fell 254 basis points in 2008 in its biggest slide since 2001, headed further lower as investors speculated the lower inflation would give more room for the central bank to cut rates.

The yield was at 5.24 per cent by 1021 GMT, down from 5.25 per cent on Wednesday.

Still, Indian stocks could see another round of correction in early 2009, though lower valuations and economic fundamentals should lend support later, a fund manager at Principal Asset Management said.

Besides falling domestic economic growth and a recession in countries from the United States to eurozone and Japan, investors in India will have to factor in heightened political risk with national elections due by May.

"This year should be a much better year than 2008 primarily because we are starting on a very low base, but we still have some pain to go through," Kejriwal said. Energy group Reliance Industries gained 1.9 per cent to 1,253.65 rupees after a 14 per cent jump in crude oil prices eased worries about pressure on its refining margins, traders said. The stock had fallen 57.3 per cent last year.

Foreign fund withdrawals of more than $13 billion weighed down Indian shares in 2008 after record inflows of $17.4 billion in 2007 when the BSE index had risen 47 per cent.

Analysts say a revival in the foreign portfolio investments was unlikely until the global credit situation improved.

In the broader market, gainers outpaced losers four to one on moderate volume of 316 million shares.