* European shares down 2.5 percent after Chinese stocks sink
* Chinese factory activity shrinks for 10th month
* Oil jumps on Saudi-Iran tensions but gives up gains
* Bond yields fall as investors look for safe havens (Updates throughout)
By Marius Zaharia
LONDON, Jan 4 (Reuters) - A 7 percent drop in Chinese shares on Monday halted trading in Shanghai and dragged down stock markets around the world, as investors began 2016 with fresh worries over global growth and sought the safety of bonds and gold.
Rising tensions in the Middle East added to the gloom. Oil prices soared more than a dollar to $38.50 before giving back some of those gains because of the concern over China, which looks set to remain a drag on the global economy.
Manufacturing surveys showed Chinese factory activity contracted for a 10th straight month in December and at a faster pace than it shrank in November.
China's central bank fixed the yuan at a 4 1/2-year low and mainland Chinese shares .CSI300 fell 7 percent. Stock exchanges halted trading on the first day so-called circuit breakers came into effect
The pan-European FTSEurofirst 300 index .FTEU3 fell 2.5 percent and the euro zone's blue-chip Euro STOXX 50 index .STOXX50E declined by 2.9 percent. Germany's DAX .GDAXI dropped 3.7 percent. U.S. stock futures ESc1 were down 1.7 percent.
The losses in Europe and the United States mirrored the move in MSCI's broadest index of Asia-Pacific shares outside Japan .MIAPJ0000PUS , which posted its biggest loss since Aug. 24 last year.
"(Equity) investors are not going to like the start of this year, particularly when you have news that trading was halted in China due to a market sell-off," said Naeem Aslam, chief market analyst at AvaTrade.
Global oil benchmark Brent LCOc1 , which fell 35 percent last year due because of fears of over-supply in a global slowdown, climbed more than a dollar to a high of $38.50 per barrel, then slipped back to $37.97.
The rise came as relations between leading crude producers Saudi Arabia and Iran deteriorated, raising concern supplies would be disrupted.
Saudi Arabia, the world's biggest oil exporter, cut diplomatic ties with Iran on Sunday in response to the storming of its embassy in Tehran. The attack came after the Saudis executed a prominent Shi'ite cleric on Saturday.
The Saudi riyal fell sharply against the dollar in the forward foreign exchange market. One-year dollar/Saudi riyal forwards SAR1Y= jumped to 680 points, near a 16-year high.
SAFE HAVENS
Those tensions prompted investors to seek the safety of bonds. Yields on triple-A rated German 10-year Bunds DE10YT=TWEB falling 6 basis points to 0.57 percent.
The cautious mood towards riskier assets also helped the Japanese yen. The dollar fell below 119 yen for the first time since mid-October JPY= . Gold XAU= jumped more than 1 percent to $1,073.20 per ounce.
"Concern over the health of the Chinese economy accompanied by spiking tensions in the Middle East have combined to ensure ... firm demand for safe-haven assets," Rabobank strategists said in a note.
The offshore yuan fell as low as 6.6331 to the dollar, its weakest since September 2011. Onshore, the yuan hit its lowest since April 2011, at 6.5350.
The euro firmed 0.4 percent to $1.0904 EUR= .
Investors are wondering how much further the U.S. Federal Reserve will raise rates this year after last month's rate increase, the first in almost a decade.
An immediate focus will be on Monday's ISM survey of U.S. manufacturing. The survey is expected to show manufacturing is still contracting after reaching a 6 1/2-year low in November.
"It was quite unusual for the Fed to raise rates when the ISM is below 50, (which indicates contraction). And we are likely to see another month of contraction. We have to see how long this will continue," said Masahiro Ichikawa, senior strategist at Sumitomo Mitsui Asset Management.