The new deal will see the Bombers' skipper remain with the club until at least 2013.
Watson, 25, said the timing and length of the deal means his aspirations to lead Essendon to a flag remain on track.
“It is really hard to know when your premiership window is because there are so many variables," Watson told the club website.
"The length of the contract means I will be at this club with the current group players and we will have played a fair bit of footy together over the next three years.
“You can never really know when you are going to have an opportunity, but hopefully we can experience it together in the next few years.”
The son of club legend Tim, Watson said his obvious family connection with Essendon added significance to his re-signing.
He was taken by the Bombers with a father/son pick in the 2002 NAB AFL National Draft.
"It obviously means a lot to my family and it is an important thing for the fans as well", he said.
“I am lucky to play at the same club as my dad and now I can hopefully do that for the entirety of my career.”
Essendon CEO Ian Robson said the deal was a sign of the confidence the club has in its captain, but was also made with an eye to retaining its talent.
“It was also pivotal because anyone out of contract this year of stature, experience or credibility was always going to come under the eye of the expansion teams - whether it was Gold Coast this year or GWS a year later," he said.
Robson noted that the club was in a period of transition after the departures of former coach Kevin Sheedy and players Matthew Lloyd and Scott Lucas, and praised Watson and coach Matthew Knights for their leadership.
Watson has played 101 games for the club, and leads the team in disposals this year.
