The loss is Kentucky's first of the season and will drop them from the top spot in the rankings.
Watford led the Hoosiers with 20 points while Victor Oladipo put up 13 points and 7 rebounds. Watford went 4-of-6 from three-point range en route to 20 points for the Hoosiers (9-0), who recorded their first win over a top-ranked team since beating Duke in the 2002 NCAA Tournament.
Indiana is off to its best start since 1989-90.
The Hoosiers rode Cody Zeller and Oladipo in the first half, extending an early lead to 30-22. But Kentucky fought back, scoring the final seven points of the half and keeping it close throughout the entire second half.