Rushdie's next book, Shame (1983), attacked contemporary politics in Pakistan, while his fourth novel, The Satanic Verses (1988), describeds a cosmic battle between good and evil, set in contemporary England and combining fantasy, philosophy and farce. Regarded by many critics as Rushdie's greatest book, it included an extended section that appeared to denigrate the prophet Muhammad and the Islamic faith. This apparent blasphemy caused outrage among Muslims, first in Britain and then worldwide, with book-burnings and riots in many cities. The outcry reached a peak in 1989 when Iran's spiritual leader, Ayatollah Ruhollah Khomeini, issued a fatwa (legal opinion) against Rushdie.

The fatwa had the force of law in Islamic terms and decreed that Rushdie deserved to die, having blasphemed against Islam. A large bounty was offered to anyone who would execute him and the author was forced into hiding, with full-time police protection, a condition that endured for many years. The fatwa was not formally lifted until 1998.

Despite a situation that might have come out of one of his own books, Rushdie continued to write. In 1990, a book for children, Haroun and the Sea of Stories, was published followed in 1995 by The Moor's Last Sigh, which some critics considered to surpass the imaginative brilliance even of Midnight's Children. This book was also not free from controversy, since it attacked the corruption and violent politics of his native city of Bombay.