In this paper, a CFD model coupled with detailed chemical mechanism is established based on a common rail diesel engine test platform, the effect of oxygen concentration on diesel engine combustion process is investigated, and the enhancement in thermal efficiency with direct water injection is verified. The calculation results indicate that the in-cylinder specific heat ratio can be improved by increasing oxygen concentration, which results in an elevated in-cylinder pressure and temperature during compression stroke, promotes in-cylinder combustion reactions, enhances in-cylinder turbulence kinetics, and results in an advanced combustion phase. By injecting 160°C high temperature and high pressure water at 5°CA ATDC, the in-cylinder combustion process can be optimized. The injected water absorbs combustion heat and evaporates into steam which further propels the piston during expansion stroke, thus increasing the overall thermal efficiency of the diesel engine by about 3.75%.