The 56-year-old MSP entered a plea bargain at Edinburgh Sheriff Court today after originally denying starting the fire at Prestonfield House Hotel during earlier court appearances.
The former Scottish Sports and Culture Minister's legal team announced in court that he intended to resign as an MSP, triggering a by-election in his Glasgow Cathcart constituency.
The incident - which was captured on the hotel's CCTV - happened when Lord Watson of Invergowrie was attending the Scottish Parliament's Politician of the Year Awards last November.
The court deferred sentencing until September 22 so that social work reports can be prepared on the Labour Lord.
The offence of willful fire- raising can carry a sentence of anything from probation to life imprisonment depending on the seriousness of the individual case.
However, in instances, such as this, when little damage is done and no lives are lost often it results in a non-custodial sentence.
If Lord Watson is sentenced to any more than one year in jail, he would automatically be barred from being an MSP.
There are likely to be calls for him to be stripped of his peerage, although his criminal conviction will not mean he is automatically barred from the House of Lords.
Prosecutors today accepted a not guilty plea to a second charge that he had started another fire in the hotel's Yellow Room.
In court, the Labour Lord admitted that on November 12 last year he entered the reception area of the hotel and set fire to a curtain. The court heard that fire took hold and the walls and ceiling were damaged.
After the private function, staff on duty noticed that Lord Watson, of Fairfax Avenue, Glasgow, appeared drunk and was acting strangely as he was looking for his coat.
Fiscal Depute Adrian Fraser said the accused was also approaching staff and being rude to them as they would not serve him wine. He said that CCTV footage showed the accused entering the reception area and taking something from the fireplace. He then lifted up a lamp from the fireplace and started to point it around the room as if it was a torch. He was then seen bending down for a number of seconds at the curtain that was set on fire, the court heard.
Mr Fraser said: "As the accused left he placed something in the sporran of the kilt he was wearing. Although other people are seen on the CCTV footage, only the accused approached the curtain.
"Footage also showed the accused returning to the room shortly thereafter, looking over at the burning curtain as if checking the situation. The accused then left and made no attempt to report what he had done or the fact that the curtain was burning."
The court heard that shortly afterwards the alarm was raised and staff found the reception room filled with black smoke and the curtain on fire.
The accused was later found with matches that he had attempted to conceal, said Mr Fraser.
Lord Watson was then ushered from the building as staff did not want to raise the subject of what had happened with him for fear of his reaction. He was later interviewed by journalists at two national newspapers when he denied he had committed an offence.
The guilty plea effectively spells the end of Lord Watson's political career. He had already been suspended from the Labour Party, pending his court appearance, and sources say he will almost certainly now be expelled because of the seriousness of the crime.
One MSP said: "It is very a sad situation. Most people put it down to drink. It is a salutary lesson in what can happen."
Lord Watson had appeared in court as recently as Tuesday this week and denied both charges against him.
The case was deferred for negotiations between prosecutors and his defence team.
The prosecution had been due to call 24 witnesses, including detectives, a fire officer, hotel staff and journalists.
The fire was started during a private drinks party after the award presentations had ended.
Lord Watson, who is also a director of Dundee United Football Club, was responsible for bringing forward the controversial members' bill that led to the ban on hunting with dogs in Scotland.
He was appointed Culture, Tourism and Sport Minister when Jack McConnell became First Minister in 2001.
However, he was axed from the Cabinet after the last Holyrood election in 2003.
ONE-TIME LABOUR FOLK HERO NEVER FAR FROM CONTROVERSY
MIKE WATSON has never been far from controversy throughout his political career - from fighting a bitter battle to save his Commons seat to successfully arguing for the ban on fox-hunting
He became a Labour folk hero in 1989 when he won the Glasgow Central by-election at a time when Labour feared the seat could have been lost to the Scottish Nationalists. But with the seat due to be abolished under boundary changes before the 1997 general election, he was plunged into a selection battle with Mohammed Sarwar for the redrawn Glasgow Govan seat. Mr Watson won by just one vote, but after allegations of foul play, the contest was re-run and Mr Sarwar emerged victorious.
He was given a seat in the House of Lords as compensation and worked as a director of a public relations company in Edinburgh between 1997 and 1999.
Watson returned to elected politics in 1999 when he became MSP for Glasgow Cathcart in the first Scottish Parliament elections.
First Minister Jack McConnell made him minister for culture, tourism and sport, but he was reshuffled out of the Executive and became deputy convener of the parliament's enterprise and culture committee.