Udinese and Watford are owned by the Pozzo family, who also control La Liga outfit Granada.
As a result, Vydra was loaned to the Championship club in the 2012-13 campaign and the Czech Republic international proved a hit.
The forward – who was at West Brom last term – has signed until the end of the 2014-15 season.
A Watford statement read: "Watford FC can today (Thursday) announce the signing of Matej Vydra on an initial season-long loan.
"The striker enjoyed a fruitful season at Vicarage Road during 2012-13 when he hit 22 goals and collected the Championship Player of the Season award for his displays during his first campaign in England.
"After returning to Udinese during the summer of 2013, the striker moved on loan to Premier League side West Bromwich Albion."
Vydra scored just three goals in 25 appearances in all competitions for West Brom last term.