There appears to be a bug. I'm sure there will be yet-another patch released in the near future (weeks at most).
At the moment some users cannot unlock their Apple Watch using the passcode. These tend to be corporate users with management profiles installed that require using the iPhone to unlock the Apple Watch. These users would benefit from turning off the "Unlock with Apple Watch" Covid-19 mask wearing option.
I for example, can do a dance that allows me to have the Unlock with Apple Watch enabled and unlock my Apple Watch with my iPhone, but the dance has to be down just right and there is a very narrow window to start and complete the dance.
- iPhone off (blank screen)
- Raise Apple Watch and wait for numeric passcode lock screen to appear
- As soon as you see the Apple Watch numeric passcode lock screen, wake the iPhone, and unlock it.
If you let the iPhone wake before the Apple Watch passcode screen appears, it will not work. If you wait too long, after the passcode screen appears, it will not work.
This is also not an option for finger print ID based iPhones. I think on those models, it just does not work unless the "Unlock with Apple Watch" is disabled. I do not have a Finger Print ID iPhone any longer, so I cannot test and verify.
So if you can get my narrow window dance to work for you, then you can have both. If you cannot get the dance to work, then you have to decide for the next few days/weeks which feature is more important to you.
Once Apple fixes this, you will be able to have both.