During data hiding, distortions are introduced in an original image because of quantization errors, bit replacement, or truncation at the gray-scale limit. These distortions are irreversible and visible, which is unacceptable in some applications such as medical imaging. However, the reversible watermarking technique over-comes this problem by retrieving the original image from the water-marked image. We present a novel reversible watermarking algorithm with a high embedding capacity considering the human visual system (HVS). We use the arithmetic coding technique to compress a part of the original image and store the compressed data together with necessary authentication information as the payload. The payload is then embedded within the original image with consideration of the HVS. Due to this, the watermarked image contains no perceptible artifacts. During the extraction phase, we extract the payload, restore the exact copy of the original image, and verify the authenticity. Experimental results show that our method provides a higher embedding capacity compared to the other algorithms proposed in the literature. © 2005 SPIE and IS&T.