The Chelsea midfielder, 18, arrived at Vicarage Road in August and has been an integral part of the club's promotion push, making a total of 18 appearances.
And Chalobah, an England Under-21 international, will now complete the season with the Hornets after they agreed an extension with the European champions.
Manager Gianfranco Zola told the club's official website: "It's great news for us. He has become an important player for us since he came to the club.
"His performances have been getting better and better so we are delighted that Chelsea have decided to leave him here.
"It's good for Nathaniel and it's also good for Chelsea because he is getting a lot of benefit from this experience," added the former Chelsea attacker.
"It is a huge boost because if we want to keep improving and chasing the teams in front of us we need to have good players and Nathaniel is one of them."