Sources with knowledge of the contract told ESPN.com that Watson received a one-year deal worth $2.8 million.
The 6-foot-1 veteran was waived earlier this month by Oklahoma City. He also has played with Seattle, Memphis and Denver in eight NBA seasons.
Watson adds depth to an Indiana team that has already lost one guard, Jarrett Jack, in free agency and is likely to lose another, Marquis Daniels, this offseason. Last week, the Pacers declined to match Toronto's $20 million offer sheet for Jack. Daniels' agent has said he is heading to Boston.
Watson has averaged 7.3 points and 4.6 assists over his career, including 6.6 points and 5.8 assists last season for the Thunder.
Information from The Associated Press and ESPN.com senior NBA writer Marc Stein was used in this report.