Although exhaust gas recirculation (EGR) is widely implemented to suppress the NOx, it can increase soot emissions and decrease the thermal efficiency in internal combustion engines. Water-emulsified diesel is a promising alternative approach, as it decreases soot emissions, suppresses NOx formation, and promotes thermal efficiency through improved mixing between the fuel and air. Based on the inhibiting functions of oxygen dilution and emulsified diesel on engine emissions, a visualization study on the spray combustion of water-emulsified diesel was experimentally explored in a constant volume combustion chamber at various ambient oxygen concentrations. This study firstly examined the different combustion characteristics of water-emulsified diesel and pure diesel. Secondly, the effects of ambient oxygen concentration on combustion characteristics of water-emulsified diesel and pure diesel were investigated. Furthermore, the characteristics of soot formation and oxidation during the combustion process were revealed by flame features observed using optical techniques. Experimental results showed that a micro-explosion arose in the emulsified diesel spray which promoted mixing between the fuel and air. Local temperatures were reduced due to water’s high specific heat and latent heat of vaporization, which also played important roles in ignition. The high specific heat and latent heat of vaporization had stronger effects than micro-explosions in the combustion process. The combined functions of the micro-explosion event, specific heat and latent heat of vaporization significantly decreased the soot emissions in water-emulsified diesel. Additionally, the ambient oxygen concentration affected the integrated flame luminosity and soot formation of the water-emulsified diesel. However, there were no obvious effects of the explored ambient oxygen concentrations on the ignition limit, flame boundary and flame area. The results showed that when the requirement of NOx emissions was held constant, the use of water-emulsified diesel could decrease the need for oxygen dilution by 10%.