The deal is subject to international clearance, the promoted Premier League club said on their website on Monday.
Diamanti, 32, who has 17 caps, previously played in the Premier League with West Ham United, scoring eight goals in 30 appearances in 2009-10.
He spent the second half of last season on loan at Fiorentina and has also had stints with Bologna, Brescia and Livorno.
A skilful playmaker with a deft left foot, Diamanti is a free kick specialist and will add depth and quality to Watford's squad under new Spanish manager Quique Sanchez Flores.
(Reporting by Tim Collings, editing by Tony Jimenez)
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