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Etienne Capoue side-footed Watford ahead in the 27th minute at a blustery Vicarage Road as the hosts controlled the first half but Palace responded strongly after the break.
Michy Batshuayi punished a defensive lapse to equalise for Roy Hodgson's side just past the hour mark and it was Palace who looked to have the upper hand moving into the closing stages.
But Watford secured a last-four date at Wembley when Gray, who had just replaced Will Hughes, volleyed a 79th-minute winner to send their fans home dreaming of a second FA Cup final appearance after they lost the 1984 showpiece.
They had to survive a late scare though when Palace's Aaron Wan-Bissaka drilled a low shot wide after a defensive blunder.
Tearful Watford goalkeeper Heurelho Gomes was given an emotional ovation at the end in what could be the Brazilian's final appearance at Vicarage Road.
He has only played in the FA Cup run this season with Ben Foster first choice in the league and the 38-year-old said afterwards he is '99.9 percent' certain to retire to become a pastor at the end of the season when his contract expires.
Watford manager Javi Gracia, in his first full season at the club, said his side had "suffered" in the second half but was confident Gray could make the difference.
"It was a difficult moment when Palace equalised but I was confident we would be able to win the game," he said. "We are ambitious. We want to achieve the final, that is our target."
Gomes was the first keeper called into action when he saved low down from Luka Milivojevic's shot but it was his opposite number Vincente Guaita who was busier.
He saved well from Gerard Deulofeu but was at fault soon after when Jose Holebas's corner left him in no man's land and Craig Cathcart prodded the ball back for Capoue to sidefoot high into an unguarded net.
Guaita made amends, keeping out a fierce drive by impressive Barcelona academy product Deulofeu.
Relegation-threatened Palace, without injured Wilfried Zaha, improved after the break and Watford began to look jittery.
In the 62nd minute Adrian Mariappa dithered on the ball and was dispossessed by Batshuayi who advanced before opening up his body and shooting past Gomes.
Roared on by their vocal fans, Palace looked likely to inflict more FA Cup heartbreak on Watford, who they beat in the semifinal three years ago, but they were stopped in their tracks as Hodgson suffered a third quarter-final defeat.
In a rare Watford attack Roberto Pereyra's superb pass picked out the run of Gray and he got just enough on his stretching volley to guide the ball past Guaita, sealing a hat-trick of 2-1 wins over Palace this season.
"We weathered a storm in the first half and when we equalised I felt good about our chances," Hodgson said.
"We were looking dangerous and the Watford crowd had gone very quiet."
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