The production of conventional crude oil and bitumen often faces the challenges in removing residual water from stable water-in-oil emulsions. The chemical demulsifier is commonly employed to enhance water removal because of its high efficiency and simplicity in operation. In this study, a novel magnetic demulsifier with a surface-active ethyl cellulose (EC) grafted on magnetic nanoparticle surfaces, called M-EC, was investigated for water removal from water-in-diluted bitumen emulsions. The M-EC was demonstrated to be interfacially active and magnetically responsive. The interfacial activity of EC on the surface of novel M-EC nanoparticles allowed them to be effectively attached to otherwise stable emulsified water droplets in diluted bitumen emulsions. The M-EC tagged water droplets were readily removed by an external magnetic field. When a simple magnetic separation was combined with tagging of emulsified water droplets by M-EC nanoparticles, our experimental results showed a more than 90% removal of the original water from the diluted bitumen. Such a combination led to a separation time about 10 times faster than corresponding demulsification by chemical EC. The external magnetic field was found to enhance the coalescence of magnetically tagged water droplets in emulsion, producing a much smaller volume of sludge and hence leading to a minimal hydrocarbon loss to waste aqueous phase. The chemical bonding of interfacially active EC on the surface of magnetic nanoparticles and the magnetic property of M-EC allowed the spent M-EC nanoparticles to be readily recovered by magnetic separation and regenerated by solvent washing. The regenerated M-EC was found to retain its interfacial activity and be effective in breaking the diluted bitumen emulsions after reuse for 10 cycles. Application of M-EC nanoparticles to an industrial bitumen froth showed a minimal water removal of greater than 80%, demonstrating their promising applications to industry demulsification. The current study demonstrated that magnetic demulsification with tailor-designed magnetic demulsifiers represents a new direction of removing emulsified water from heavy oil and diluted bitumen emulsions.