Consumers in the world's biggest democracy just got a big surprise.

Indian Prime Minister Narendra Modi on Tuesday announced that 500 and 1,000 rupee banknotes would be withdrawn from circulation at midnight, saying it was part of a crackdown on rampant corruption and counterfeit currency.

India is hampered by so-called black money that is undeclared, untaxed or under the table, said Sasha Riser-Kositsky, lead South Asia analyst at research firm Eurasia Group. The unexpected step appears designed to bring billions of dollars worth of cash in unaccounted wealth into the mainstream economy, as well as hit the finances of Islamist militants who target India and are suspected of using fake 500 rupee notes to fund operations.

"The move to restrict the circulation of large-denomination currency notes represents a major step in the government's fight against black money," Riser-Kositsky said.

Speaking in an address to the nation, Modi said that black money "and corruption are the biggest obstacles in eradicating poverty." New 500 and 2,000 rupee denomination notes will be issued at a later date, he added.

Those notes are worth roughly $7.53 and $30.14, respectively, but they represent very large-denomination bills in the country. The average daily income in India was 272.19 rupees in 2014, or about $4.09 at today's conversion rate, according to the country's Labor Bureau.

"It shows resolve on the part of the government to do something about black money, which I like a lot," a hedge fund investor who is active in India but requested anonymity told CNBC. The investor added, however, that "I do think there's going to be a backlash. A lot of the economy is still cash-driven, and this will inconvenience a lot of people and transactions."

Indeed, Sameer Samana, a global quantitative strategist at Wells Fargo Investment Institute, told CNBC that the move could unintentionally tighten monetary policy by reducing the circulation of larger notes. Samana added that "in the near term, it's a negative mainly because of the tighter financial conditions."

The iShares MSCI India ETF was lower Tuesday, despite the currency rising (Exchange: INR=). Modi's announcement came after markets closed in India.

"This news is particularly bad for cash-driven industries like luxury, jewelry and real estate. Stocks that could be under pressure tomorrow (include jewelers) Gitanjali, Titan, PC Jeweller," said Neil Nathwani, executive director of institutional equity sales, at BNP Paribas Securities. "You're no longer going to see women going to the store with a big stash of cash to buy diamonds."

Kositsky pointed out that Modi's first official act after his 2014 election campaign was to set up a special investigation team into black money and bring it back into the above-board economy. Critics have said it had failed to deliver on that promise.

Tuesday's announcement comes just more than a month after the government raised nearly $10 billion through a tax amnesty for Indians to declare hidden income and assets. A report by Washington-based think tank Global Financial Integrity estimated that India lost $344 billion to illicit fund outflows between 2002 and 2011.

Modi also said militants operating against India were using fake versions of the 500 rupee note, worth about $7.50 at current exchange rates. India has been locked in a perpetual fight against terrorists and insurgents whom New Delhi claims are supported by archrival Pakistan.

"Terrorism is a frightening thing. ... But have you ever thought about how these terrorists get their money? Enemies from across the border have run their operations using fake currency notes. This has been going on for years," Modi said.

India accuses its neighbor Pakistan of harboring militants who have launched attacks on its troops, particularly in the disputed Himalayan region of Kashmir, which both countries claim. Pakistan denies the accusations.

— Reuters and CNBC's Everett Rosenfeld contributed to this report.

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