The day after my last post the "unlock Mac with Apple Watch" feature stopped working. Frustration and despair.
Coincidentally I was listening to an episode of John Gruber's podcast "The Talk Show" for which he had John Siracusa as his guest. They two discussed the state of Apple's OSes and in particular macOS. One of Siracusa's main gripes are the countless small problems with macOS. They are nothing major but together they degrade its usability and the overall experience.
I wanted to see if turning off the "unlock with Apple Watch" option in macOS Preferences and the Handoff options on my Mac, iPhone and Watch would solve the problem so I turned them off and on one by one. No luck. The problem continued.
I then turned off "unlock with Apple Watch" in macOS preferences as well as Handoff on my Mac, iPhone and Apple Watch. I then rebooted all devices. The problem continued for a while and then magically it worked.
The next day, due to other Bluetooth problems with the iMac's mouse, trackpad and keyboard, I reset the Bluetooth module and then did a factory reset of all connected Bluetooth devices. These two options are in the Bluetooth menu holding down alt and shift.
All Bluetooth problems seem to be resolved. The Apple Watch unlocks the iMac, the keyboard, mouse and trackpad don't disconnect and the MacBook Pro does not trigger a connect screen on the iMac.
Fingers crossed.