Blues fought off interest from other clubs to bring the player on a short-term loan until the end of the season.
The pacy 32-year-old winger has been with the Hornets since last summer, after joining them following a successful six-year spell with Leicester City. In his final season with the Foxes he was a key member of the side as they won promotion to the Barclays Premier League.
Following his move to Vicarage Road, there have been several changes in management and Dyer has not had as much game time as he would have liked. In the campaign to date he has made 16 appearances, but 12 of those have come from the substitutes' bench. He has still managed three goals and his last appearance was in their 1-0 win away at Reading just before Christmas.
Birmingham-born Dyer began his professional career at West Bromwich Albion in 2000. He spent six years at the Hawthorns before moving to Millwall, where he was there for just two months. Two years at MK Dons followed, before he moved to the East Midlands to link up with Leicester City. He now has more than 400 career appearances under his belt.
Dyer, who will wear the number 40 jersey during his time at St. Andrew's, will be eligible to play in Saturday's FA Cup fourth round tie against his former club West Brom. However, he will not be able to play against his parent club in April.