The Hornets first registered an interest in the 25-year-old last summer, but had their £2m approach rejected.
But Watford boss Aidy Boothyroyd has remained keen on the wide man and has fought off interest from Premiership new-boys Derby to see his renewed offer accepted.
McAnuff has signed a three-year contract for the Vicarage Road side in a deal that could rise to £2m.
He played 83 times for Palace, scoring 14 goals and will always be remembered for his injury time winner as the Eagles came from behind to win 3-2 at Brighton in 2005/6.