At 1.30 p.m., the Sensex traded 411 points or 2.3 per cent higher at 18,432 while the broader Nifty advanced 129 points to 5,564.
Stocks jumped to new seven-month highs after the government announced a hike in diesel prices and after the Federal Reserve announced a new asset purchase programme.
The US Federal Reserve's decision to launch a third round of quantitative easing sent stocks soaring worldwide. Indian markets are trading at the highest level since February 2012.
The Fed said it would buy $40 billion of mortgage securities a month until the US economy improves. Fed's decision would lead to a rise in liquidity in the global economy giving a push to riskier assets like equities and commodities.
The government's decision to hike diesel prices raised hopes that reforms might be coming back on tracks. Investors have been concerned over the rising subsidy bill because state-run oil refiners have been selling fuel at below market prices.
The government hopes the move will help avert a sovereign credit downgrade, the prime minister's chief economic advisor, C. Rangarajan, said. "The government has shown it can take hard decisions, very difficult decisions."
The cabinet's economic panel is due to meet on Friday to discuss a plan to invite foreign airlines to invest in domestic carriers and a proposal to sell shares of large state-run firms. All these developments point to a decisive shift in the government's thinking on the economy, analysts said.
"Fuel price announcements coupled with positive global news flows will provide another boost to markets. This rally should continue in near term," Jagannadham Thunuguntla, head of research at SMC Investments and Advisors told Reuters.
Lenders gained on expectations the fuel price hike would increase the prospect of rate cuts, given Reserve Bank of India officials were seen as wanting the government to shore up its finances before considering easing monetary policy. State Bank of India rose 4.4 percent, while ICICI Bank rose 4.4 percent.
Shares in software services exporters and metals rose after the Fed launched an aggressive stimulus program, saying it would pump $40 billion into the U.S. economy each month until it saw a sustained upturn in the weak jobs market.
Tata Steel rose 4 per cent; Hindalco Industries jumped 7.2 per cent, while Infosys advanced 1.9 per cent.
Airlines rose on hopes that the sector would benefit from a potential opening up of the sector. SpiceJet extended gains for a third day, up 5 per cent.
(With inputs from Reuters)