The 33-year-old made just four appearances for the Hornets in the Championship last season in a campaign affected by a problem with his Achilles.
Cleverley featured 181 times in all competitions across two separate stints for the club, scoring 19 goals.
In a statement on Instagram, Manchester United academy graduate Cleverley said: "Unfortunately my body has failed me and just hasn't got the capacity to perform anymore."
Watford Chairman and CEO Scott Duxbury said: "No one could have worked harder than Tom did to make it back from several injuries, which he's tried to do while always providing a positive force around the players."
Despite the latest news, the Hornets said that 'exciting news will soon be announced jointly by the club and Tom.'
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Cleverley was part of the youth set-up at Bradford City before signing for Manchester United in 2000 at the age of 11.
Following loan spells at Leicester, Watford and Wigan, he made his competitive debut for United in the 2011 Community Shield win against Manchester City.
He featured a further 14 times in the club's midfield under Sir Alex Ferguson across all competitions that season.
Cleverley departed United at the end of his contract in 2015 with five goals in 79 appearances, as well as one Premier League title and two Community Shields winners' medals.
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He then completed a move to Everton but played just a season-and-a-half at Goodison Park.
The midfielder's return to Watford was sealed in January 2017 initially on loan before being made permanent that summer.
Cleverley helped keep the side in the Premier League in 2018 and 2019 but was part of the squad that were relegated to the Championship in 2020.
He and the Hornets sealed an instant return to the top flight before heading down to the second tier once again in 2022, playing just 244 minutes of football last season before retiring.