This paper proposes a fractal-based image encryption algorithm which follows permutation-substitution structure to maintain confusion and diffusion properties. The scheme consists of three phases: key generation process; pixel permutation using the Knuth shuffle method; and the dynamic diffusion of scrambled image. A burning ship fractal function is employed to generate a secret key sequence which is further scanned using the Hilbert transformation method to increase the randomness. The chaotic behavior of the fractal strengthens the key sensitivity towards its initial condition. In the permutation phase, the Knuth shuffle method is applied to a noisy plain image to change the index value of each pixel. To substitute the pixel values, a dynamic diffusion is suggested in which each scrambled pixel change its value by using the current key pixel and the previously ciphered image pixel. To enhance the security of the cryptosystem, the secret key is also modified at each encryption step by performing algebraic transformations. The visual and numerical analysis demonstrates that the proposed scheme is reliable to secure transmission of gray as well as color images.