The 34-year-old announced the decision after sustaining a calf injury in Saturday's one-day victory over England that ended his tour, Cricket Australia (CA) said on their website.
"I announce my retirement from test cricket today with a heavy heart," Watson, who finished his 59-match test career with 3,731 runs and a 35-plus average, said in a CA statement.
"I have given my all to be the best I can be, physically, technically and mentally, and while I have not always achieved the personal goals that I set myself in test cricket, to have played over 50 tests and to have captained my country is more than I ever dreamed of."
Watson, who remains available for one-dayers and Twenty20 Internationals, played his last test in the Ashes opener at Cardiff before being dropped from the Australian side who lost the series 3-2 last month.
Two other members of Australia's losing Ashes party -- Michael Clarke and Chris Rogers -- have also announced their international retirements.
"On this tour I have seen how the next generation of young Australian cricketers are ready to take the game forward," Watson said.
"I hope to continue to represent my country in both shorter formats of the game, and I believe that I still have a significant amount to contribute."
Since his 2005 test debut against Pakistan, regular hamstring and back injuries have taken toll on Watson's body and his stock has fallen considerably over the last couple of years.
Once the golden boy of Australian cricket, Watson lost his place at the top of the batting order and his bowling, which earned him 75 test wickets and was once considered essential to the team balance, has also lost some of its bite.
"He has been an outstanding contributor to the team on and off the field and a great thinker on the game as well as a hugely talented cricketer," coach Darren Lehmann said.
"Behind the scenes he has done so much work with our younger players and that has been something that has impressed me."
Skipper Steve Smith said he was among those who benefitted from Watson's experience.
"It has been a pleasure to play alongside Shane and he has been a huge influence on my career and the team as a whole," said Smith.
(Reporting by Amlan Chakraborty in New Delhi; editing by Mike Colett and Martyn Herman)
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