The west London charity, which first threatened legal proceedings earlier this month (Third Sector, 9 April), has accused the funder of being unfair and ignoring evidence.
"This action has not been taken lightly," said Karam Bhuller, chair of Watermans. "It is an expensive and disruptive process."
An Arts Council spokeswoman said: "We considered Watermans' response to our funding proposal carefully.
"Despite investments aimed at stabilising Watermans, our concerns about artistic and audience growth and fundraising remain, and we do not believe that the current building is a viable investment."