The ban rules him out of the fourth and final Test against Australia starting November 6 in Nagpur.
"India opener Gautam Gambhir has received a one Test ban after being found guilty of breaching the ICC Code of Conduct during the third Test against Australia in New Delhi," the ICC said in a statement.
Gambhir had elbowed Watson while taking a run on the opening day of the ongoing match after a heated exchange with the Aussie all-rounder.
The Indian met match referee Chris Broad this morning before the start of third day's play where he was informed of the penalty.
"The decision to find Gambhir guilty of a level 2 offence is indicative of the fact that any degree of physical contact is unacceptable," Broad said.
The hearing had been adjourned last evening to allow the match referee to review the evidence.
The opener pleaded guilty to a charge under Rule C1 of the Code (Level 2) which states that "players shall at all times conduct play within the spirit of the game."
Gambhir banned for one Test match
Watson was found guilty of "verbally engaging" with Gambhir "in a manner that was not in keeping with the Spirit of Cricket" and fined 10 per cent of his match fee on Thursday.
Broad said Gambhir could have been charged under a stronger code according to the rules, but he decided on a lighter sentence as umpires Billy Bowden and Aleem Dar had highlighted the provocation by Watson.
"Had Gambhir been charged with and found guilty of a charge under 2.4, due to his previous offence, I would have been obliged to impose a minimum penalty of a two-Test match ban. In the view of the umpires, the facts of this case - the lightness of the physical conduct and the element of provocation - would not justify such a penalty," he added.
Broad said Gambhir's punishment was decided after taking into account his past disciplinary record.
"The ICC has repeatedly told the players that deliberate physical contact between players will not be tolerated. I have also taken into account the previous offences of Gambhir and therefore, I am satisfied that the penalty imposed is an appropriate outcome in the circumstances of this matter. I hope Mr Gambhir will learn from this," he said.
Present at the hearing was Gambhir himself, Broad, umpires Bowden and Dar, third umpire Suresh Shastri and fourth umpire Sameer Bandekar, India coach Gary Kirsten and captain Anil Kumble.
The penalty for a Level 2 offence is a fine of between 50 and 100 per cent of the player's match fee or a maximum ban of one Test match or two ODIs.
For Level 2 offences, players have the right to appeal against an adjudicator's decision within 24 hours of notification of that decision.