Classification of stress tolerant cotton genotypes is a challenge for breeders and physiologists. In quantitative genetics, diallel analysis is a mating design used to identify superior genotypes for hybridization and selections programmes. Twelve popular cotton cultivars viz., ‘CRIS-134’, ‘CRIS-342’, ‘Sadori’, ‘Chandi’, ‘Sindh-1’, ‘NIAB-78’, ‘CIM-496’, ‘CIM-499’, ‘CIM-506’, ‘CIM-534’, ‘BH-160’ and Bt-cotton (Australian origin) were screened at seedling and reproductive stages and six genotypes such as CRIS-134, Sadori, Sindh-1, CIM-496, CIM-506 and CIM-534 were recognized as reasonably drought tolerant based on developmental, yield, fibre and physiological characters. For further confirmation of drought tolerant cotton genotypes, fourteen drought tolerance indices based on various mathematical approaches were applied. When comparing twelve cotton varieties on only yield basis, high and positive correlation (r=0.66**) between the yield in drought stress (Ys) and yield in water stress conditions (Yp) suggested that majority of the varieties performed similar in both the environments. Out of twelve, six genotypes such as CRIS-134, Sadori, CIM-496, Sindh-1, and CIM-506 produced higher seed cotton yields both in non-stress and in water stress, hence these genotypes were declared as drought tolerant. Through 6 x 6 half diallel diallel mating fashion, 15 F1 hybrids were developed for genetic analysis. The experiments were carried-out in factorial design with two irrigation regimes (non-stress and water stress at reproductive stage) in four replications at experimental field, Department of Plant Breeding and Genetics, Sindh Agriculture University, Tandojam during 2009 to 2011. The yield, fibre and physiological traits were consisted of bolls opened at 110 days after planting, plant height (cm), sympodial branches plant-1, bolls plant-1, boll weight (g), seed cotton yield plant-1 (g), seed cotton yield (Kg ha-1), lint%, seed index (g), staple length (mm), fibre strength (tppsi), leaf area, relative water content (%) and stomatal conductance (mmol m-2s-1). In screening experiments, at developmental and reproductive stages of crop, water stress significantly affcteted shoot length, root length, number of lateral roots, leaf area, relative water content, excised leaf water loss, stomatal conductance, and stomatal density. The significance of treatments x genotypes interactions revealed that cotton cultivars performed variably over irrigation regimes. The significance of mean squares for general combining ability (GCA) and specific combining ability (SCA) for most of the characters under water stress and normal irrigation indicated that both additive and non-additive genes were equally important in advocating the characters studied. However, in stress imposed at reproductive phase, the SCA variances were higher than GCA for plant height, boll weight, seed index, leaf area, relative water content and stomatal conductance indicating the predominance of dominant genes for these traits. Nonetheless, GCA variances were greater for other traits such as bolls opened at 110 days after planting, sympodia plant-1, bolls plant-1; seed cotton yield kg ha-1, lint%, staple length and fibre strength and such results indicated predominance of additive genes advocating the above characters. The parents CRIS-134, Sadori, and CIM-534 with higher GCA estimates proved as good general combiners for hybridization and selection programmes so as to evolve novel moisture stress tolerant breeding material. From hybrids, crosses Sadori x Sindh-1, CRIS-134 x Sadori, CIM-496 x CIM-534, Sadori x CIM-534 and CIM-496 x CIM- 534 by expressing higher SCA effects for majority of traits were considered as good specific combiners, thus they are suitable for hybrid cotton development for both stress and non-stress environments. From 15 hybrids evaluated, five potential hybrids such as Sadori x CIM-534, Sadori x Sindh-1, CIM-496 x CIM-534, Sadori x CIM-534 and CRIS-134 x CIM-496 manifested higher heterotic effects and high SCA estimates for majority of traits under stress are suitable combinations for hybrid cotton development. Three types of gene interactions such as additive x additive, additive x non-additive and non-additive x non-additive were involved in the manifestation of higher heterosis in the above hybrids based on GCA estimates of parents involved in above particular hybrids. The broad sense heritability estimates in stress conditions were, by and large, greater than in non-stress environment such results indicated that yield, fibre and physiological traits are mainly advocated by the additive genes; hence selection would be rewarding to improve studied traits for drought tolerance in earlier segregating generations. The narrow sense heritability estimates were far lower than broad sense heritability in either non-stress or in water stress conditions and such results suggested that selection in later segregating generations may be more successful. The combined correlation coefficients (r) determined from pooled data of parents and their F1 hybrids revealed that by and large, the correlations were higher in moisiture stress than in non-stress environment. In stress conditions, the high positive association between yield, fibre and physiological traits suggested that plant height, sympodia plant-1, bolls plant-1, boll weight, seed cotton yield, lint%, staple length, fibre strength were significantly and positively correlated with leaf area, relative water content, yet all these traits were negatively correlated with only stomatal conductance. These positive correlations indicated that more than one trait can be used as selection criteria to aid selection process under water stress conditions.