Two new water soluble squaraine dyes, bis[3-(p-carboxybenzyl)benzothiazol-2-ylidene]squaraine (Sq1) and bis[3-(carboxymethyl)benzothiazol-2-ylidene] squaraine (Sq2), have been synthesized and their photophysical properties have been characterized. Sql and Sq2 form dimer aggregates in water that have absorption bands blue-shifted to those of the monomeric forms. Aggregate formation is more preferred in D2O than in H2O. In the presence of low concentrations ((3 x 10(-4) M) of poly(vinylpyrrolidone) (PVP), enhancement in aggregate formation of Sql is observed, whereas that of Sq2 remains unaffected. Higher concentration (>3 x 10(-4) M) of PVP leads to the disruption of the aggregate and formation of a new species with absorption bands red-shifted to those of the corresponding monomers. The nature of these interactions has been investigated. It is proposed that hydrophobic interaction between the chromophoric units is the major driving force for the formation of the H-type (sandwich) aggregates in water. The red-shifted species are attributed to the monomeric forms, microencapsulated in a hydrophobic environment provided by PVP. Picosecond laser flash photolysis studies of the aggregates show clear evidence for the breakup of the aggregate from the excited state to yield an excited state-ground state monomer pair that rapidly recombines to reform the ground state dimer.