The 22-year-old, who originally signed for the Hornets on a season-long loan, has scored three goals for Gianfranco Zola's side since making his debut against Bolton in September.
And the Argentina-born forward, who has represented Italy at Under-20 level, has spoken of his delight at sealing the move.
|MONDAY TRANSFER ROUND-UP
|6.50||Watford are 6.50 with bet365 to gain promotion to the Premier League this season
Forestieri told the club's official website: "I’m unbelievably happy to be signing for Watford. I have enjoyed the town and the club so far, as well as the support of the fans.
"Life feels good at Watford and it feels like home. I love working with people here and I feel protected. I would like to thank Lucas [my agent], as well as Gian Luca Nani, Scott Duxbury and the staff from Watford for their help and support.
"I will give my heart for the club."