iOS 14.7.1 does not resolve this problem for me. I use an iPone 12 Pro Max with 14.7.1 and an Apple Watch 6 with WatchOS 7.6
Try unpair then pair again.
Note: The Watch passcode screen should be visible when you unlock with your paired iPhone.
Turn off "Unlock with Apple Watch" under iPhone settings -> Face ID & Passcode (for touch ID, it may be slightly different title).
If you want both, you may be able to do the following dance (assuming you have Face ID; not sure if this will work for Finger Print Reader iPhones)
iPhone screen blank (screen off)
Raise Apple Watch until the numeric passcode unlock screen appears.
Then immediately wake the iPhone and unlock it.
If you wake the iPhone too early, it will not work.
If you wait too long to wake and unlock the iPhone, it will not work.
Apple Watch does not unlock iPhone
