Goldman Sachs Group Inc.—one of the few Wall Street titans to thrive during the financial crisis—was charged with deceiving clients by selling them mortgage securities secretly designed by a hedge-fund firm run by John Paulson, who made a killing betting on the housing market's collapse.

Goldman vigorously denied the Securities and Exchange Commission's civil charges, setting up the biggest clash between Wall Street and regulators since junk-bond king Drexel Burnham Lambert succumbed to a criminal insider-trading investigation in the 1980s, helping to define the era. "The SEC's charges are completely unfounded in law and fact," Goldman said in a statement, promising to "contest them and defend the firm and its reputation."

The civil charges against Goldman and one of its star traders, 31-year-old Fabrice Tourre, represent the government's strongest attack yet on the Wall Street dealmaking that preceded, and some say precipitated, the financial crisis that gripped the nation and the world. Goldman's shares fell 13%, one of the steepest slides since the firm went public in 1999, erasing some $12 billion of market capitalization.

The SEC lawsuit likely strengthens the position of President Barack Obama as he tries to push financial-overhaul legislation through Congress. He vowed Friday to veto any version of the bill that doesn't bring the derivatives market "under control."

Regulators say Goldman allowed Mr. Paulson's firm, Paulson & Co., to help design a financial investment known as a CDO, or collateralized debt obligation, built out of a specific set of risky mortgage assets—essentially setting up the CDO for failure. Paulson then bet against it, while investors in the CDO weren't told of Paulson's role or intentions.

"The product was new and complex, but the deception and conflicts are old and simple," said Robert Khuzami, the SEC's enforcement chief.

Mr. Paulson and his firm aren't named as defendants. The hedge-fund firm said in a statement that it wasn't involved in marketing the bonds to third parties. "Goldman made the representations, Paulson did not," Mr. Khuzami said.

Mr. Paulson took home $4 billion in 2007 for correctly betting on a housing collapse.

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The SEC said Mr. Tourre was "principally responsible" for piecing together the bonds and touting them to investors. According to the SEC, Mr. Tourre wrote in an email shortly before the bonds were sold that "the whole building is about to collapse anytime now." He described himself in the email as the "Only potential survivor, the fabulous Fab … standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!"

But he was hardly alone, the SEC alleges: The deals were signed off by senior Goldman executives, though the SEC didn't specify how high up it believes the knowledge extended.

In the past year, Goldman—the most profitable firm on Wall Street—has emerged as a symbol of excess. The taxpayer-funded rescue of the markets helped catapult Goldman to a huge profit rebound last year and stirred resentment of the firm's bonuses. Goldman paid out about $16 billion in compensation to employees in 2009.

And late last year in a profile in London's Sunday Times, Goldman's chief executive, Lloyd Blankfein, described himself as "doing God's work," a remark that Goldman later explained was made in jest. Still, the quip inflamed Goldman critics who said it showed the firm was tone deaf about concerns over its business practices and rich pay.

Goldman is one of the few financial firms the U.S. government has accused of misleading investors in the subprime-mortgage debacle, although it is one of many that created and sold securities that cratered when the housing market collapsed.

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The new Goldman Sachs Group headquarters in New York's lower Manhattan.

The Dow Jones Industrial Average fell 116.38, or 1.04%, to 11028.19, as investors worried that other financial firms could be on a collision course with the SEC over Wall Street's behavior during the crisis.

It has been a brutal week for Goldman. The SEC's charges against the firm came just days after The Wall Street Journal reported that prosecutors are investigating Goldman director Rajat Gupta on suspicion that he provided inside information to the Galleon Group, the hedge fund founded by Raj Rajaratnam now at the center of the biggest insider-trading probe in decades.

The deal at the center of the SEC suit came as Goldman and other firms were deeply involved in making, buying and building complex investments out of subprime loans, just as the market for those loans was beginning to weaken perilously. Critics of such deals say they enriched the firms but magnified what became the worst financial crisis since the Great Depression.

As the housing market sank in 2007 and 2008, investors in the deal, known as Abacus 2007-AC1, suffered losses of more than $1 billion, according to the SEC. The sinking market gave Paulson a profit of about $1 billion. Goldman was paid about $15 million for structuring the bonds and pitching them to investors. Goldman is a major trader of stocks and bonds on behalf of Paulson

In a statement, Goldman said it suffered a $90 million loss on the deal. Goldman said investors were provided with extensive information about the securities in the portfolio. Mr. Tourre, the trader facing civil charges as part of the SEC action, couldn't be reached to comment. He works as executive director in Goldman's international unit.

Analysts said the suit could cost Goldman business and even threaten its executives. "Someone must 'fall on their swords' for the devastating decline in this company's persona," wrote Richard Bove, an analyst with Rochdale Securities.

Goldman and Mr. Tourre both received Wells notices from the SEC in recent months indicating that the staff of the agency could recommend action against the parties in the case, a person familiar with the matter said. Goldman isn't required to disclose the Wells notice if it believed it wasn't a material event. The notices don't always lead to charges or fines.

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