Europe's standoff with Russia has affected the region's largest economy after economic confidence in Germany nosedived unexpectedly, fuelling fears the eurozone's weak recovery will be snuffed out.

Hostility between the west and Vladimir Putin over Russia's treatment of Ukraine is already hurting the German economy, according to a closely watched survey of investor mood.

The ZEW indicator of economic sentiment plunged more sharply than expected to a 20-month low of 8.6 points from 27.1 points in July. Economists polled by Reuters had forecast a far smaller drop, to 18.2 points.

Economists said it was a worrying sign of faltering confidence in Germany, which has been instrumental in lifting the wider eurozone out of the worst of the crisis and was the UK's second largest trade partner in terms of good exports last year. The imposition of tit-for-tat sanctions between Russia and the EU, with Brussels banning exports such as oil and gas equipment to Russia and the Kremlin retaliating with an embargo on European food imports, has hit confidence.

"Fear is back," said Carsten Brzeski, an economist at ING. "The German ZEW just sent more signs of caution, showing that at least financial market participants are increasingly becoming pessimistic."

The extent of Germany's woes will be laid bare on Thursday when the first official estimate of second-quarter GDP is expected to show zero growth, following a 0.8% rise in the first quarter.

Brzeski said the danger for Germany was that a weak second quarter could turn into something more serious. "Looking ahead, today's ZEW sends a worrying signal that the growth performance in the second quarter could suddenly morph from a one-off into an undesired trend. Up to now, the fallout of the Ukraine crisis has been limited to a general return of uncertainty and a sharp drop in German exports to Russia. Obviously, a further escalation of the crisis could start to really hurt the economy."

The ZEW index, which measures investors' expectations for the economy in six months' time, has fallen for eight consecutive months amid weak growth in the eurozone overall – the UK's biggest trading partner. Growth in the eurozone is expected to have slowed to 0.1% between April and June from 0.2% in the first three months of the year. The fear is that heightened tensions will be enough to halt the fragile recovery.

Germany stands to be among the hardest hit by the west's stance on Russia because it is Russia's biggest trading partner within the EU.

The authors of the ZEW report said the decline in economic sentiment was the result of the geopolitical tensions that have begun to weigh on Germany's growth.

"In particular, current figures on industrial production and incoming orders suggest markedly reduced investment activities on the part of German firms against the backdrop of uncertain sales prospects. Since the economy in the eurozone is not gaining momentum either, the signs are that economic growth in Germany will be weaker in 2014 than expected."

The European Central Bank (ECB) made clear last week that it is ready to unleash quantitative easing in the eurozone should the outlook for the currency bloc worsen. Inflation in the 18-member region slipped to 0.4% in July from 0.5% in June, reigniting fears that the eurozone is moving dangerously close to deflation.

Meanwhile, new data from Portugal showed weak demand is damaging the eurozone's periphery. Figures from the Portuguese statistics office on Tuesday showed deflation accelerated in July, with prices falling by 0.7% over the year. It was worse than expected after economists predicted inflation would remain unchanged at June's rate of -0.2%.

The fear is that falling prices will trigger a deflationary spiral, where consumers and businesses put off purchases because they are expecting prices to fall further.

Mario Draghi, the ECB's president, said last week the region's recovery remained "weak, fragile and uneven", and warned sanctions and counter-sanctions between the west and Russia were among the biggest risks facing the eurozone economy.

"Geopolitical risks are heightened. And some of them, like the situation in Ukraine and Russia, will have a greater impact on the euro area than they … have on other parts of the world," Draghi said.

He added however that measures announced in June were starting to be successful. At that point the ECB cut the main interest rate to 0.15%, imposed a negative rate of -0.1% on bank deposits, and announced a €400bn (£317bn) package of cheap finance to encourage bank lending.