The Oscar-nominated actress, whose big screen credits include Mulholland Drive, The Ring and J. Edgar, has secured the coveted role in German filmmaker Oliver Hirschbiegel's (Downfall) movie.
The Help's Jessica Chastain was rumoured to be attached to the Diana part in Caught in Flight last year.
The movie, to be produced by Ecosse Films, will track the last two years of the Princess's life as she transforms into a "major international campaigner and humanitarian".
Watts said of her casting: "It is such an honour to be able to play this iconic role - Princess Diana was loved across the world, and I look forward to rising to the challenge of playing her on screen."
Director Hirschbiegel added: "I am delighted to have such a truly exceptional actress who embodies the warmth, humanity and empathy of such a global icon as Princess Diana."
A rival Diana biopic from producer Stephen Evans is also in the works, with Charlize Theron and Carey Mulligan tipped to take on the lead role and Ewan McGregor linked to the part of the Princess's bodyguard Ken Wharfe.