Labour said the MP had resigned yesterday, but senior sources insisted Mr Watson had been sacked from the key post.
Unite – one of Labour's biggest union backers – has been accused of hijacking the general election process to select a candidate in Falkirk to replace disgraced MP Eric Joyce.
Mr Watson's aide Karie Murphy, Unite's candidate in Falkirk, together with Stephen Deans, the chairman of Falkirk Constituency Labour Party, who also chairs the Unite union in Scotland, were suspended.
Labour leader Ed Miliband later told Unite he would not tolerate abuses of membership and selection procedures in "my party".
He said: "I am incredibly angry about what's happened in Falkirk because I feel the good name of Labour Party members, trade union members and the Labour Party have been besmirched by the behaviour of a few individuals.
"That's why we suspended the local party. That's why we have now suspended two individuals.
"I want to be very clear about this: I am not going to have abuse of membership procedures, of parliamentary selections, in my party."
But, last night, Mr Miliband's attempt to take the initiative suffered another blow when Unite general secretary Len McCluskey branded the party's investigation into allegations against his union in Falkirk a "stitch-up." He insisted trust in Labour headquarters had gone and called for an independent inquiry into the selection row.
Stung by David Cameron's taunts that he is weak, Mr Miliband yesterday made the decisive moves as the first steps in achieving his promise to loosen the trade unions' historic grip on the party.
However, Mr Watson's departure threatened to reignite Blairite/Brownite tensions.
In his resignation letter to Mr Miliband, the West Bromwich East MP hit out at colleagues for briefing against him and suggested some had never forgiven him for quitting government to force the departure of Tony Blair seven years ago.
In another move, Mr Miliband announced the scrapping of the policy of allowing trade unions to pay the subscriptions of their members to join the Labour Party – which was at the heart of claims Unite sought to flood Falkirk Labour Party with more than 100 of its members to ensure Ms Murphy was selected. The union insists it has done nothing wrong.
One senior source said: "There will be more moves to weaken the unions' influence, starting with the National Executive Committee."
It is thought Mr Miliband will try to reduce the number of union members on the NEC's organisation committee, which oversees candidate selections.
Last night, a spokesman for the Labour leader confirmed the selection process in Falkirk had been suspended, pending investigations into the suspensions of Ms Murphy and Mr Deans.
He explained they had been suspended because of allegations they may have broken Labour Party rules, relating to "allegations concerning potential abuse of membership rules".
In his resignation letter, Mr Watson, revealed he had offered his resignation on Tuesday when the temperature in the Falkirk row rose with Mr McCluskey threatening legal action and Tory headquarters writing to the Information Commissioner to query whether there had been a breach of the Data Protection Act. One claim was that at least one Unite member was signed up to the party in Falkirk without his prior consent.
Mr Watson told Mr Miliband: "I offered my resignation ... and you asked me to reconsider. I've thought about it and still feel it is better for you and the unity of the party that I go now."
He added: "Yet it's not the unattributed Shadow Cabinet briefings around the mess in Falkirk that has convinced me that the arrangement has run its course [though they don't help].
"The report should be published – in full – and the whole truth told."
Mr McCluskey later called on Mr Miliband to restore integrity to Labour's "discredited inquiry" into the Falkirk selection by handing it over to an independent third party.
In a letter to Iain McNicol, Labour's General Secretary, the Unite chief branded the Falkirk report a "stitch-up designed to produce some evidence, however threadbare, to justify pre-determined decisions".
Mr McCluskey said it was "noteworthy members of the Shadow Cabinet have been in the lead in initiating this attack upon Unite," thought to be a dig at Jim Murphy, the Shadow Defence Secretary, who claimed Unite had overstepped the mark in Falkirk.
Calling for an independent inquiry, he added: "The mishandling of this investigation has been a disgrace. I, however, am obliged to uphold the integrity of Unite and I can no longer do so on the basis of going along with the activities of a Labour Party administration in which I can place no trust."
Meanwhile, the Conservatives sought to maintain the political pressure.
Party Chairman Grant Shapps described Mr Watson's resignation as a "clear vote of no confidence in Ed Miliband's weak leadership".
He also challenged the Labour leader to come clean about Mr McCluskey's "takeover" of his party after a leaked document suggested the union had been working to get favoured candidates selected in 41 seats.