Watson was expected to be a key player in both the Ashes Tests and tri-series with his solid batting and pace bowling, but has missed almost the entire season with a recurring hamstring injury.
Having proven his fitness in domestic cricket, he has been recalled to replace injured Queensland teammate Andrew Symonds in a 13-man squad for the best-of-three finals series.
Chairman of selectors Andrew Hilditch said Watson's allround talents were needed in light of the injury to Symonds.
"Shane has been given a full medical clearance and has successfully returned to domestic cricket," Hilditch said in a statement released on Tuesday.
"We feel the time is now right for him to return to international cricket.
"Shane adds a great balance to the Australian one-day side and was an important member of the victorious Australian side at the ICC Champions Trophy."
Unlucky paceman Shaun Tait, who bowled a 160-kilometres-an-hour (99-miles-an-hour) delivery in returning 1-26 from 10 overs in just his second one-day international against New Zealand on Sunday, has been dropped from the squad.
Test star Stuart Clark was also surprisingly axed, while spinner Brad Hogg has been retained despite playing just one game in the tri-series.
Hilditch said the omission of Tait and Clark was a simple matter of team balance and that both were still in contention for the World Cup.
"With Shane Watson returning to the side there is no need to continue with five specialist fast bowlers in the squad," he said.
"Both Stuart and Shaun were unlucky to be omitted and remain very much in contention for selection in the ICC Cricket World Cup squad, which will be named at the conclusion of the finals series."
Hilditch said Hogg had been rewarded for his good form domestically and would be considered when pitch conditions were suitable.
Squad:Ricky Ponting (captain), Adam Gilchrist (vice-capt, wk), Mike Hussey, Brad Hodge, Matthew Hayden, Michael Clarke, Glenn McGrath, Brett Lee, Nathan Bracken, Brad Hogg, Mitchell Johnson, Shane Watson and Cameron White.