Murray signed a deal until 2015 earlier this year, but has now extended that until 2017.
The 18-year-old scored seven goals in 19 starts for Watford last season.
“This is going to let me get on with my football,” he told the club’s official website.
“I want to work even harder to try and get some goals and become a really important player for the team.
“I didn’t need any persuasion to sign. I love it here, I’ve always loved being part of the club so to know that’s going to carry on for another five years is great.”
He added: “I’ve been here 10 or 11 years already and this is a really good time be around the place.
“I think the team we have now and the way we are playing, the manager and the staff, we’ve got a chance to push for promotion.”
Murray has been linked with the likes of Fulham and Everton in recent weeks.
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