Watson was born in Islington, London, England, the daughter of an architect father and an English professor mother. She was raised in the Anglican religion. Watson trained at Drama Studio London and holds a BA (1988, English) as well as an MA (2003, honorary) from Bristol University, UK. Watson married Jack Waters, whom she had met at the Royal Shakespeare Company, in 1995; their daughter, Juliet, was born in autumn 2005.

Watson is a committed supporter of the British children's charity, the NSPCC. In 2004 she was inducted into the society's hall of fame for spearheading the successful campaign to appoint a Children's Commissioner for England. Receiving her award in the crowded House of Commons, she spoke out against the possibility that the Children's Commissioner become a figurehead with little real power.

Watson was virtually unknown until director Lars von Trier chose her to star in his controversial Breaking the Waves after the first choice, Helena Bonham Carter, dropped out over the uncompromisingly bleak eroticism and the graphic nudity demanded for the role. Her performance as Bess McNeill was her first in front of a camera, and became the most critically acclaimed of 1996. She won the Los Angeles, London and New York Critics Circle Awards, the US National Society of Film Critics Award for Best Actress, and ultimately an Oscar nomination.

She came to public notice again in another controversial role, as cellist Jacqueline du Pre in Hilary and Jackie, for which she learned to play the cello herself, and received another Oscar nomination. Despite this, many of du Pre's friends and fans decried the film's portrayal of her as inaccurate and unfair. She also played a leading role in Cradle Will Rock, a story of a theatre show in the 1930s, directed by Tim Robbins. Though she won the title role of Frank McCourt's mother in the adaptation of his memoir, Angela's Ashes, the film underperformed. In 2001, she appeared alongside John Turturro in chess biopic The Luzhin Defence, and as a member of Robert Altman's ensemble piece Gosford Park.

In 2002 she starred as Reba McClane in the adaptation of Thomas Harris's The Silence of the Lambs prequel, Red Dragon, as the romantic interest of Adam Sandler in Paul Thomas Anderson's curious and quirky Punch-Drunk Love, and in the sci-fi action thriller Equilibrium alongside Christian Bale. The following year she took time off from the cinema to play two roles in Sam Mendes's dovetailed stage productions of Uncle Vanya and Twelfth Night, first at Mendes's Donmar Warehouse in London and later at the Brooklyn Academy of Music. Her performance was widely acclaimed on both sides of the Atlantic and garnered her an Olivier Award nomination. In 2004 she received a Golden Globe nomination for her role as Peter Sellers's first wife, Anne Howe, in the HBO movie, The Life and Death of Peter Sellers.

2005 saw her starring in four films: Wah-Wah, Richard E. Grant's autobiographical directorial debut, for which she attended the UK premiere at the Edinburgh Festival; Separate Lies, directed by Gosford Park writer Julian Fellowes; Tim Burton's animated film Corpse Bride, alongside Johnny Depp and Helena Bonham Carter, and Nick Cave's Australian-set western, The Proposition. In 2006 she took a supporting role in Miss Potter, a biopic of children's author Beatrix Potter from Babe director Chris Noonan, with Ewan McGregor and Renée Zellweger, and also in an adaptation of Thea Beckman's children's novel Crusade in Jeans. In 2007, she appeared in The Water Horse: Legend of the Deep, an adaptation of the Dick King-Smith children's novel about the origin of the Loch Ness Monster.

Next, she will star with Julia Roberts and Carrie-Anne Moss in Fireflies in the Garden, and has also signed to star with Paul Giamatti in Cold Souls, from first time director Sophie Barthes. She will also star in screenwriter Charlie Kaufman's directorial debut, Synecdoche, New York and Within the Whirlwind, a biopic of Russian poetess Evgenia Ginzburg, from Luzxhin Defence director Marleen Gorris. She is slated to appear in Fellini Black and White, as the wife of film director Frederico Fellini. The film depicts a trip made by the director to receive an award and also stars Antonio Banderas, Liv Tyler, Laurence Fishburne and Peter Dinklage.

In 2007, Mood Indigo, a script written by Watson and her husband, was optioned by Capitol Films. The film is a love story set during World War II and concerns a young woman who falls in love with a pilot.

Director Jean-Pierre Jeunet wrote the character Amélie for Watson to play (Amélie was originally named Emily) but she eventually turned the role down due to difficulties speaking French and a desire not to be away from home. The role went on to make an international star of Audrey Tautou.[17] She was also the first choice to play Elizabeth I in Shekhar Kapur's film Elizabeth, the role that ultimately made a star of Cate Blanchett.

Although best known internationally for her film roles, Watson is also a veteran of the stage. Her theatre credits include Three Sisters, The Children's Hour (at the Royal National Theatre) and The Lady From The Sea. In Autumn 2002, Watson starred at the Donmar Warehouse Theatre in two concurrent productions: Uncle Vanya ( where she played Sonya) and Twelfth Night (Viola), both directed by Academy Award winning director Sam Mendes. These productions also ran in a very limited engagement at the Brooklyn Academy of Music in New York City. She has also worked extensively with the Royal Shakespeare Company in such productions as Jovial Crew, The Taming of the Shrew, All's Well That Ends Well and The Changeling.