Watkins, from Wokingham, and partner Grainger have now won 23 consecutive races and are unbeaten in two years.
Finally Grainger can banish the memories of three successive Olympic silver medals and savour the moment she won gold at her home lake in Eton Dorney.
The pair finished with clear water between them and the Australians in an extraordinary finish.
Watkins said: "I just can't believe it, I just had to ask Katherine if it was a dream."
Earlier, Reading's Will Satch won an unlikely bronze medal in the men's pair final at Eton Dorney.
Satch, at just 22, finished third with partner George Nash in a time of 6 minutes 21.77.
Reading University Boat Club member Charles Cousins also finished fifth in the men's quadruple sculls final.
The quad had already made history by being the first British quad to make an Olympic final.
Germany won gold ahead of Croatia and Australia but the GB crew were in the bronze medal position after 500m and doing well but were unable to keep up with the relentless pace of the Germans.