The 33-year-old missed Australia's recent tour of Zimbabwe with an ankle problem but was on track to play in the three-format series against Pakistan in the Middle East.
However, an issue with his right calf has halted his progress and the all-rounder will now be forced to sit out of the tour.
His absence will give fellow all-rounder Mitchell Marsh a chance to make his Test debut, with the 22-year-old already in the touring party after solid performances in the recent tri-series against Zimbabwe and South Africa.
Tasmanian veteran Ben Hilfenhaus has been called in to replace Watson in the Tests, with Peter Siddle, Mitchell Johnson and Mitchell Starc the only other full-time quicks in the squad.
Young South Australian Kane Richardson will step into Watson's place in the T20 and One Day International side.
Cricket Australia physiotherapist Alex Kountouris said that while Watson was looking on track to make a return to international cricket, the timing of his latest injury forced him out.
"While Shane has made steady progress with his rehabilitation after he stepped on a ball and sprained his ankle, he has suffered a setback, experiencing some right calf soreness," Kountouris said.
"As Shane has previously had similar calf injuries, we plan to hold back his return to running and bowling for approximately 7-10 days. The unfortunate timing of this calf injury will mean that his preparation for the UAE Tour will be considerably affected and he would have been unavailable for the T20 and ODI part of the tour and significantly limit his bowling preparation for the Test matches."
Chairman of selectors Rod Marsh said the decision to leave Watson out of the squad was a tough one but was made with one eye on the upcoming home Test series against India.
"Shane has done everything he can to get up for this tour and left no doubt in our minds that he wanted to push through. Had the decision been left to Shane, he would be on the plane to Dubai, however as selectors we have taken a conservative approach to ensure he has the best chance of being fit for the big summer ahead," Marsh said.
"Right now we believe the best thing for Shane is to stay home and get 100 per cent fit as we know what a dynamic and destructive player he can be when his body is right. He remains an integral part of our plans for the summer."
Watson admitted he was disappointed with his latest injury setback but conceded it was the right decision give his body the best chance of recovering ahead of the Australian summer.
"I’m naturally disappointed because I was desperate to play against Pakistan which is our opportunity to get back to number one in Test and one-day international cricket.
"Despite my strong desire to be on the tour, I understand why the selectors have made this decision. Given I can’t be with the boys, my goal now is to work as hard as I can to get back to 100 per cent fitness so that I can make myself available for selection ahead of our series against South Africa in November,” Watson said.
"I’ve been here before and know what I need to do to get back to full fitness. That means remaining positive and working hard. We have a huge summer of cricket at home and my priority now is to play a big part in that."