"That is total rubbish. I did a full and thorough medical and simply had a change of heart and decided not to sign," he said.
"Watford would not have made me a two-year offer if they had any doubts about my physical condition and don't forget I played 45 matches last season."
The Hornets captain won the club's players' player-of-the-year award last season and was expected to be in high demand.
"There was interest from elsewhere in John, but I'm very pleased he's decided to stay," said boss Malkay Mackay.
"The way he has carried himself this season is a credit to himself and he was outstanding for us."
Eustace joined the Hornets from Stoke on transfer deadline day in January 2008 but found himself out of favour 12 months later, leading to a loan move to Derby County.
The arrival of Mackay as manager in June 2009 signalled a fresh start for the former Coventry trainee, who made 45 appearances this season, scoring four goals.
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