After Darren Ward's opener against his first club had been cancelled out by Darius Henderson, Andy Johnson secured the Eagles' third straight win over the festive period from the penalty spot after referee Phil Dowd had adjudged that Clarke Carlisle had fouled Clinton Morrison.
However, the decision looked harsh as there was no clear contact and Morrison appeared to go to ground easily.
Despite that the Hornets had their chances to avoid a sixth defeat of the season, the best falling to unmarked substitute Ashley Young but he somehow failed to convert an Anthony McNamee cross from four yards out.
Palace were the better side in the first half and deservedly took the lead when Watford failed to deal with a Jobi McAnuff free-kick from wide on the left and Ward was presented with a straight forward finish from inside the six-yard box.
In a bid to kick-start his side Watford boss Adrian Boothroyd made an early change bringing on Young for Matthew Spring, but it took a fine save from Ben Foster to prevent the visitors doubling their lead after McAnuff's low drive.
But Watford came out for the second period in far more positive mood and levelled after catching the Palace defence cold.
A quickly taken Gavin Mahon free-kick from inside his own half picked out Marlon King and his flick fell perfectly for Henderson who got clear of Tony Popovic to drill a left-footed cross shot beyond Gabor Kiraly.
The Palace keeper then excelled to deny Carlisle from close range before the referee's controversial intervention gave Johnson the opportunity to put the visitors back in front.
Young then missed his great chance, but still the home side kept looking for the equaliser with King hitting a shot on the turn straight at Kiraly and then, deep into injury time a McNamee corner picking out the unmarked James Chambers in the area but his header was safely gathered by the Palace keeper.