On 15 November 2004, Lord Watson was charged with two counts of "wilful fire raising" after a private reception at Edinburgh's Prestonfield Hotel following the Scottish Politician of the Year awards on 11 November. The first alleged that he set fire to a curtain in the hotel's reception, and the second that he set fire to a curtain in the hotel's Yellow Room. On being charged, the Labour whip was suspended in the Holyrood and Westminster parliaments.

After initially registering not guilty pleas to both charges on 23 August 2005, he changed his plea on 1 September to guilty on the first count, and had a not guilty plea accepted on the second charge.

On the same day that Lord Watson admitted his guilt, he resigned from the Scottish Parliament. He resigned as a director of Dundee United Football Club. It was not possible for a life peer to resign from the House of Lords at that time and there was no provision for peers convicted of criminal offences to be stripped of their titles. Such legislation was last proposed following the conviction of Jeffrey Archer for perjury in 2001, but rejected. The House of Lords Reform Act 2014 made resignation possible.

On 22 September 2005, Lord Watson was sentenced to 16 months' imprisonment. Sheriff Kathrine Mackie justified the sentence, stating that there was both "a significant risk of re-offending" and that Lord Watson offered no explanation. She also told Lord Watson that consumption of alcohol "neither excuses nor fully explains your behaviour". The sentence was reduced from 20 months to 16 because Watson had pleaded guilty before the case reached trial. Watson appealed against his sentence on 23 March 2006 but the appeal judges refused to cut the term, and he was returned to prison. After serving half of his sentence (eight months), he was released on 23 May 2006.