Two people -- a male student and a female crew member -- were confirmed dead as the vessel sank 20 kilometres off the southern island of Byungpoong.
The government retracted an earlier announcement that 368 people had been rescued, and said it could only confirm that 164 people had been brought to safety.
"The remaining 293 are unaccounted for," Lee Gyeong-Og, the vice minister of security and public administration, told a press briefing in Seoul.
Dramatic television aerial footage showed terrified passengers wearing life jackets clambering into inflatable boats as water lapped over the rails of the vessel as it sank.
Some could be seen sliding down the steeply inclined side of the ferry and into the water, as rescuers, including the crew of what appeared to be a small fishing boat, struggled to pull them to safety.
Of the 429 passengers on board the ferry which had been bound for the popular southern resort island of Jeju, more than 300 were students travelling with 14 teachers from a high school in Ansan just south of Seoul.
Many of those saved appeared to have been rescued by fishing and other commercial vessels who were first on the scene before a flotilla of coastguard and navy ships arrived, backed by helicopters.
Lee said divers, including a team of South Korean navy SEALS, were searching the submerged vessel.