It will be the Navarrese coach's second spell in charge of a team he led to the FA Cup final in 2019.
He was there from January 2018 until September the following year, managing to keep them in the Premier League in both seasons.
However, a poor start to the 2019/20 campaign left him out of credit, and he was sacked.
A club statement on their website read: "Watford FC is delighted to confirm the return of Javi Gracia as head coach after deciding to part company with Paulo Pezzolano and his support staff, whom we sincerely thank for their efforts and commitment during their time in charge.
"We wish them every success in the future."
Pezzolano, a former Valladolid coach, managed the Hornets for just 10 games, leaving them currently 11th in the Championship.