Raheem Sterling scored his first goal for the club and Fernandinho netted a superb second to lift City to their fourth successive win and open an eight-point advantage over Chelsea.
The Stamford Bridge side’s underwhelming start to the season continued despite Radamel Falcao’s first goal for the club, Joel Ward grabbing the Palace winner nine minutes from time to put his side second in the table.
“Raheem played very well, it was good for him to score,” City manager Manuel Pellegrini told the BBC. “He worked very hard and I’m sure he’ll score more goals.
“It was not frustrating in the first half. You can’t expect to win the game inside 45 minutes against a team who defends well. We made some changes and we created more chances and won the game.”
City had begun the season in ominous form with impressive wins over West Bromwich Albion, Chelsea and Everton, scoring eight goals and conceding none.
The hosts, however, struggled to break down a Watford side who had not tasted defeat in three matches following their promotion to the top flight.
After a frustrating first half against a spirited Watford, Sterling ghosted into the box and converted Bacary Sagna’s cross in the 47th minute to open his account in sky blue.
That lifted the tension which had been building and City played with added freedom, doubling the lead nine minutes later through Fernandinho following a sublime one-two with David Silva.
Chelsea have yet to get going having cantered to the title last season and were frustrated by Alan Pardew’s well-marshalled Palace side.
Chelsea dictated possession and had 13 shots in the first hour but looked uncomfortable against Palace’s razor-sharp counter-attacks.
With Chelsea fans beginning to grow restless at their sides lack of final product, Bakary Sako pounced to convert Yannick Bolasie’s dangerous cross — his second goal in as many games since joining the south London club.
Falcao headed home his first Blues goal 14 minutes later to restore parity before Ward stabbed in a late winner as Jose Mourinho suffered only his second league defeat in 100 home games as Chelsea manager.
“Crystal Palace were always dangerous and in their counter-attacks they scored two goals,” Mourinho told Sky Sports.
“We had our goal that put the game completely open but immediately after they scored. It should be a draw which is still a bad result.”
Liverpool, who had taken seven points from their opening three games, slumped to a surprise 3-0 home defeat by West Ham United and had midfielder Philippe Coutinho sent off.
Manuel Lanzini and Mark Noble, who was later sent off, gave West Ham a 2-0 halftime lead before Diafra Sakho sealed the visitors’ first win at Anfield since 1963 with a goal in stoppage time.
Newcastle United’s Fabricio Coloccini scored an own-goal as Arsenal laboured to their second win of the season with a highly-charged 1-0 victory over their 10-man hosts at St James’ Park. Aleksandar Mitrovic was dismissed early in the first half.
Tottenham Hotspur’s winless start to the season continued when they were held to a goalless draw by fellow European hopefuls Everton at White Hart Lane.
Sunderland remained bottom after an eventful 2-2 draw at Aston Villa with goals from Yann M’Vila and Jeremain Lens cancelled out by Scott Sinclair’s brace for the hosts.
Promoted Bournemouth drew 1-1 with Leicester City after Jamie Vardy cancelled out Callum Wilson’s fourth goal in two games.
Club-record signing Salomon Rondon scored to give West Bromwich Albion a 1-0 victory over Stoke City who had Ibrahim Afellay and Charlie Adam sent off.
(Editing by Ed Osmond)