The Northern Irish racer posted a lap of 123.650mph on his Classic Suzuki XR69 - in the best conditions of the week so far.
Michael Rutter, Ivan Lintin and Dean Harrison and James Hillier all posted laps in excess of 122mph.
Practice will continue on Thursday, with the start of racing on Saturday.
Bruce Anstey completed his first practice lap of the week (113.776mph) in the Lightweight class to sit just one second off Ian Lougher's fastest lap.
Following a red flag incident at Creg ny Baa and a short delay, Conor Cummins posted the quickest lap of the Classic TT session (107.199mph).
Dunlop also topped the Junior Classic timesheets with a lap of 102.082mph.
Isle of Man rider Andrew Dudgeon continued to set the pace in Manx Grand Prix qualification, the Ramsey man posting a time of 117.824mph on the GSX-R Suzuki he will ride in both the Junior and Senior MGP races.
Fellow Manx rider Michael Evans topped the MGP Newcomers A leaderboard with 112.591mph.
Due to a lack of practice time, Manx Grand Prix competitors will have practice on Thursday.
In the Newcomers A session three riders - Andrew Cuthbert (Sarah's), Shaun Wynne (Creg Ny Baa) and James Hinchcliffe (Graham's) - were to taken to hospital after separate crashes.
Michael Dunlop - 123.650mph
Ian Lougher - 113.893mph
John McGuinness - 107.199
Michael Dunlop - 102.082mph
Andrew Dudgeon - 117.824mph

The Aurora Australis had broken free of its mooring lines on Wednesday following a severe blizzard.
The Australian Antarctic Division (AAD) said a barge ferried the expedition members to the Mawson research station after weather conditions improved.
Thirty-one crew members remain onboard to refloat the vessel.
The AAD said the refloating process, where the crew will attempt to move the ship off the rocks, would take several hours, and that afterwards the ship would be taken to a nearby sheltered area for inspections.
The vessel incurred a small breach in the hull when it ran aground, which the AAD said poses no risk to the ship's stability or to the environment. It added there was no fuel spilled so far.
The Aurora Australis left Hobart in Tasmania on 11 January and carried out marine science research around the Kerguelen Plateau, a submerged continent that extends for 2,200km (1,365 miles), before arriving at Mawson on Saturday.
It broke free of mooring lines at 09:15 local time (04:15 GMT) on Wednesday, amid winds of more than 130kph (80mph), and ran aground at West Arm in Horseshoe Harbour.
It was also scheduled to pick up another group of expedition members from Davis research station.
The AAD said on Friday that this group would now be flown to Casey research station, and then flown home in coming days.
The Aurora Australis, which is 95m long and weighs 3,911 tonnes, was launched in 1989 and is capable of breaking ice that is up to 1.2m thick.
The ship is designed to cope with heavy seas and contains laboratories that are used for biological, oceanographical and meteorological research. It also has a gym, library and recreation areas.
Michael Dunlop set the quickest time in qualifying at the 2016 Festival of Motorcycling for a third night in a row in the Isle of Man.
[NEXT_CONCEPT]
Thirty-seven people stranded on Australia's flagship icebreaker, which ran aground in Antarctica, have been rescued, authorities said.