Watford, who have enjoyed a recent resurgence under Nigel Pearson, will now have to play a replay after squandering a 3-0 lead.
Goals in the first half from Ayotomiwa Dele-Bashiru, Nathaniel Chalobah and Roberto Pereyra gave Watford the lead – an advantage that should have secured their place in the fourth round.
But Tranmere produced a thrilling comeback, with goals from Connor Jennings, Emmanuel Monthe and Paul Mullin securing a 3-3 draw.
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Watford made nine changes to their side for the match against Tranmere, who are currently 21st in League One.
Pearson included a mixture of fringe players and youngsters in his team and they must have already been looking forward to the fourth round at half-time.
Dele-Bashiru, a product of Manchester City’s academy, was making his first start and he needed just 12 minutes to make an impact, firing home from 25 yards out.
Chalobah made it 2-0 just two minutes later and the game already looked done and dusted.
The 25-year-old punished Tranmere after the League One side failed to clear their lines.
The third goal arrived just after the half-hour mark through Pereyra, who swept home his third goal of the game.
Tranmere boss Micky Mellon would have been eager to get his players into the dressing room and his words at half-time had a major impact.
They pulled a goal back midway through the second half through Jennings, who headed home following Corey Blackett-Taylor’s cross.
Monthe lashed the ball home 12 minutes from time to set up an exciting finish and the comeback was complete four minutes from the end when Mullin scored a penalty.
The visitors were given the chance to make it 3-3 when Watford substitute Mason Barrett fouled Blackett-Taylor inside the box.
Mullin slammed home the spot-kick to send the away fans wild.
Pereyra was sent off late on for kicking out at Kieron Morris to cap a disappointing afternoon for Watford.