Town missed out on the chance to take a grip on the race for sixth place after Anthony Wordsworth had levelled the scores at the start of the second-half at Vicarage Road.
With Reading, Blackburn and Bournemouth all losing on Good Friday and Brighton held at Huddersfield, a win would have put Blues into pole position for what looks like the last remaining Play-Off place.
A win looked a real possibility when Wordsworth cancelled out Albert Reira’s first-half goal and Luke Hyam looked certain to head Town in front on the hour until Manuel Almunia’s fingertips diverted the ball onto the bar.
Three minutes later the game swung Watford’s way when Gabriele Angella was left alone to head his side in front and two minutes later, Lewis McGugan took the game beyond Blues’ reach with a third.
Town made three changes to the side that beat Doncaster last weekend, with Frank Nouble, Wordsworth and Aaron Cresswell returning to the side. Paul Anderson missed out with a hamstring injury while Scott Loach sustained a back spasm overnight, Michael Crowe his replacement on the bench.
Daryl Murphy made himself space with a neat turn and tested Almunia with the first effort on target on 10 minutes, Jonny Williams then winning a foul on the edge of the box that almost saw Wordsworth force the ball in.
Superb defending from Cresswell robbed Mathias Ranegie 18 yards out after Troy Deeney has led a break for the Hornets, Williams then finding himself in a great position on the edge of the box but his shot went straight at Almunia.
Christophe Berra showed why he is the Town fans’ player of the year by showing pace and power to deny Deeney as the Watford striker looked to get in down the right, then on the other flank, he cut out the danger after Reira got free.
Reira was finding space down the left though and the midfielder made it pay on 23 minutes, cutting inside and curling a right foot effort beyond Dean Gerken and into the net.
More wizardry from Williams carved the Watford defence open as Blues looked for an immediate response but his cross beat Murphy in the box, Nouble then leading a charge down the left with Joel Ekstrand eventually clearing the danger.
Cresswell, a threat going forward, had to defend well at the far post after Lewis McGugan swung in a dangerous ball, Berra doing just as well to clear the danger as Deeney attacked the cross at the far post to bring a fairly even first-half to an end.
Nouble fired just wide inside the first 30 seconds of the second-half as Blues looked the get back on level terms, Berra then winning a free-kick after a 50 yard run. Murphy got on the end of the set-piece but his shot was cleared.
Deeney tested Gerken at the other end but it was Blues who carried the greater threat and right in front of the 2000 strong travelling Town fans, Wordsworth found the equaliser with a volley from Nouble’s cross on 50 minutes.
Murphy was allowed to run 30 yards at the Watford defence and it took a last ditch tackle from Ekstrand to force the ball away to safety, Angella booked for a push on Williams as the home side were forced back.
Town were inches away from going in front on the hour, the midfielder thumping a header that was finger-tipped on to the underside of the bar by Almunia.
Against the run of play though it was the home side who went in front on 63 minutes, Angella escaping the Town defence to head in from close range following a free-kick.
Two minutes later, Watford added a third, Daniel Tozser sliced through the Town rearguard and from his pull-back, McGugan buried his shot in the bottom corner.
McGugan blasted over from 30 yards as the Hornets looked to seal the points, Williams again carrying the main threat for Blues at the other end, the loanee able to beat players at will, his pass almost releasing Nouble inside the box.
A flurry of subs late on saw Paul Taylor, Paul Green and Stephen Hunt join the action, with Williams one of the Blues to make way.
Hunt went close to reducing the arrears but unfortunately not close enough, with the defeat leaving Town one point behind sixth placed Brighton and another massive game to come on Bank Holiday Monday against Play-Off rivals Bournemouth.