Chidambaram also said New Delhi was "willing to work" with Islamabad, provided Pakistan dismantled terrorist infrastructure and did business as a civilised nations.
To a question on how close Pakistan was to becoming a failed or at least a dysfunctional state, Chidambaram said, "I think many people would call it dysfunctional even today. I do not think it is a failed state but if it does not arrest the decline, it is perilously close to becoming one. It is pretty dysfunctional today".
In an interview to Karan Thapar on India Tonight programme, the home minister said India favours a stable democratic set up in Pakistan.
"We are not happy with the turmoil in Pakistan. Taliban across our border has a tendency to spill over in different ways into India," he said.
Asked if India has a stake in ensuring stable civilian rule in Pakistan, he said, "Of course a stable civilian democratic government means that we know who we are dealing with and there are checks and balances."
Chidambaram said a civilian democratic government in Pakistan is "better for us to deal with."
On the recent peace deal signed by Pakistan government in Swat and Bajaur, he said it was "very bad" for South Asia.
"We cannot countenance a regime like the Taliban that is opposed to every notion of civilised democratic government that we accept. The Taliban's influence is spreading in Pakistan. I am sorry for the people of Pakistan. But it worries me because the Taliban's influence is spreading and it could spill over to India," he said.
Asked about the proliferation of Taliban and other militant groups, Chidambaram said, "The rise of Taliban has two implications. One, it will encourage fundamentalists in India to imitate them, and number two the Taliban could become a sponsor of terror in India."
"Therefore, I do not think we in India can view this lightly. We have to take this as a very serious and grave development," he added.
To a query whether there was any sign that Taliban influence in Pakistan was encouraging fundamentalists in India, he said, "Yes, fundamentalists of both kinds." Whether he meant both Hindu and Muslim, he said "yes".
Chidambaram said people try to imitate other fundamentalist forces and elements and pointed out that there were pockets in India where it is a "growing worry", like parts of Karnataka, Orissa and Punjab where the Sikh fundamentalists were raising similar cries.
The minister felt rise of Taliban encouraged people to take to fundamentalist ways. About Uttar Pradesh and Bihar, where there is a sizeable Muslim population, Chidambaram said he had no evidence.
"There are fundamental elements in Uttar Pradesh. But, there are also fundamentalists among caste groups," he said.
To a question, the Home Minister said the United States was "quite upset" with the Pakistani government for yielding so much space to Taliban.
Asked whether he believed Pakistan President Asif Ali Zardari is sincere when he tells things which are reassuring to India, Chidambaram said "I do not have to make a judgement on his sincerity. I only need to know what he says and what he does. If there is a wide gap between what he says and what he does, then I have to keep by guard high."
On whether a wide gap exists in case of Zardari, he said, "it exists in case of every Pakistani leader who has commented on the situation post the Mumbai attacks."
To another question, Chidambaram said "Who is the real authority in Pakistan I cannot say. But if General Kayani is a moderating influence, if he has brokered a peace between the president and the Pakistan prime Minister, well, that is a good piece of news".
Chidambaram also felt that civil society engagement between India and Pakistan was "very minimal".
As to what extent the terror problem in India arose from Pakistan, he said, "almost entirely except for the insurgencies in the north eastern states. Even there one finds the hand of Pakistan occasionally."
Asked to comment on India being surrounded by a sea of uncertainty and insecurity in Nepal, Sri Lanka and Bangladesh, he said it is an "unfortunate but nevertheless largely correct conclusion".
"...We (India) are in a ring of fire. We have to be on our guard always. We have to protect our democratic institutions. We have to be eternally vigilant," the home minister said.
He felt the terror posed a threat to every country. "In the last few years, the threat of terror has increased and we are not exception," he said.
"If the states surrounding us, the countries surrounding us are more stable, more democratic, better administered, we will be happier. But I take fact as they are. It is true that we are in a very difficult situation," Chidambaram said.
Asked if India should take steps to put the fire out, the minister said, "We will try to help. If people ask for help, we will help. We have helped in bringing multi-party democracy in Nepal. I believe, in a way, we encouraged return of multi-party democracy in Bangladesh."
On whether he welcomed increasing United States' involvement in Afghanistan in building up of force levels, he declined to comment saying, "This is a call the government has to take as a whole after assessing the security situation".
Asked whether it would have security implications for India, he said whether the induction of any force alter the security situation "for better or for worse" he could not say.
"The point is India is trying to help Afghanistan find its feet. We are helping them in many ways. We have a policy on Afghanistan which is quite explicit. We have made it clear," Chidambaram added.