The England Under-21 midfielder moves to Turf Moor following temporary spells with Nottingham Forest and Middlesbrough in the Championship last season.
Chalobah becomes the second player to bolster manager Sean Dyche's squad on Monday after George Boyd's earlier arrival from Hull City on a three-year deal.
The 19-year-old won the European Under-17 Championship with England in 2010 and helped Watford to the Championship play-off final amid a successful stay in 2012-13, although he is yet to make a Premier League appearance.
He is currently on duty with Gareth Southgate's England Under-21 squad, where he is joined by new Burnley team-mate Danny Ings for European Championship qualifiers against Lithuania and Moldova.
"Pleased to join Burnley on loan. Looking forward to meeting my new team-mates after international duty," Chalobah posted via his official Twitter account.
