diff --git a/src/compiler/resolutionCache.ts b/src/compiler/resolutionCache.ts
index f2d20ab19a2..6ca318f7183 100644
--- a/src/compiler/resolutionCache.ts
+++ b/src/compiler/resolutionCache.ts
@@ -9,6 +9,7 @@ namespace ts {
         resolveModuleNames(moduleNames: string[], containingFile: string, logChanges: boolean): ResolvedModuleFull[];
         resolveTypeReferenceDirectives(typeDirectiveNames: string[], containingFile: string): ResolvedTypeReferenceDirective[];
         invalidateResolutionOfDeletedFile(filePath: Path): void;
+        invalidateResolutionOfChangedFailedLookupLocation(failedLookupLocation: string): void;
         clear(): void;
     }
 
@@ -33,8 +34,7 @@ namespace ts {
     export function createResolutionCache(
         toPath: (fileName: string) => Path,
         getCompilerOptions: () => CompilerOptions,
-        clearProgramAndScheduleUpdate: () => void,
-        watchForFailedLookupLocation: (fileName: string, callback: FileWatcherCallback) => FileWatcher,
+        watchForFailedLookupLocation: (failedLookupLocation: string, containingFile: string, name: string) => FileWatcher,
         log: (s: string) => void,
         resolveWithGlobalCache?: ResolverWithGlobalCache): ResolutionCache {
 
@@ -54,6 +54,7 @@ namespace ts {
             resolveModuleNames,
             resolveTypeReferenceDirectives,
             invalidateResolutionOfDeletedFile,
+            invalidateResolutionOfChangedFailedLookupLocation,
             clear
         };
 
@@ -185,11 +186,8 @@ namespace ts {
                 log(`Watcher: FailedLookupLocations: Status: Using existing watcher: Location: ${failedLookupLocation}, containingFile: ${containingFile}, name: ${name} refCount: ${failedLookupLocationWatcher.refCount}`);
             }
             else {
-                const fileWatcher = watchForFailedLookupLocation(failedLookupLocation, (__fileName, eventKind) => {
-                    log(`Watcher: FailedLookupLocations: Status: ${FileWatcherEventKind[eventKind]}: Location: ${failedLookupLocation}, containingFile: ${containingFile}, name: ${name}`);
-                    // There is some kind of change in the failed lookup location, update the program
-                    clearProgramAndScheduleUpdate();
-                });
+                log(`Watcher: FailedLookupLocations: Status: new watch: Location: ${failedLookupLocation}, containingFile: ${containingFile}, name: ${name}`);
+                const fileWatcher = watchForFailedLookupLocation(failedLookupLocation, containingFile, name);
                 failedLookupLocationsWatches.set(failedLookupLocationPath, { fileWatcher, refCount: 1 });
             }
         }
@@ -260,7 +258,7 @@ namespace ts {
                     });
                 }
                 else if (value) {
-                    value.forEach((resolution) => {
+                    value.forEach((resolution, __name) => {
                         if (resolution && !resolution.isInvalidated) {
                             const result = getResult(resolution);
                             if (result) {
@@ -274,9 +272,31 @@ namespace ts {
             });
         }
 
+        function invalidateResolutionCacheOfChangedFailedLookupLocation<T extends NameResolutionWithFailedLookupLocations>(
+            failedLookupLocation: string,
+            cache: Map<Map<T>>) {
+            cache.forEach((value, _containingFilePath) => {
+                if (value) {
+                    value.forEach((resolution, __name) => {
+                        if (resolution && !resolution.isInvalidated && contains(resolution.failedLookupLocations, failedLookupLocation)) {
+                            // TODO: mark the file as needing re-evaluation of module resolution instead of using it blindly.
+                            // Note: Right now this invalidation path is not used at all as it doesnt matter as we are anyways clearing the program,
+                            // which means all the resolutions will be discarded.
+                            resolution.isInvalidated = true;
+                        }
+                    });
+                }
+            });
+        }
+
         function invalidateResolutionOfDeletedFile(filePath: Path) {
             invalidateResolutionCacheOfDeletedFile(filePath, resolvedModuleNames, m => m.resolvedModule, r => r.resolvedFileName);
             invalidateResolutionCacheOfDeletedFile(filePath, resolvedTypeReferenceDirectives, m => m.resolvedTypeReferenceDirective, r => r.resolvedFileName);
         }
+
+        function invalidateResolutionOfChangedFailedLookupLocation(failedLookupLocation: string) {
+             invalidateResolutionCacheOfChangedFailedLookupLocation(failedLookupLocation, resolvedModuleNames);
+             invalidateResolutionCacheOfChangedFailedLookupLocation(failedLookupLocation, resolvedTypeReferenceDirectives);
+        }
     }
 }
diff --git a/src/compiler/watchedProgram.ts b/src/compiler/watchedProgram.ts
index 6b16474e268..c668d4a1510 100644
--- a/src/compiler/watchedProgram.ts
+++ b/src/compiler/watchedProgram.ts
@@ -255,6 +255,7 @@ namespace ts {
         let timerToUpdateProgram: any;                                      // timer callback to recompile the program
 
         const sourceFilesCache = createMap<HostFileInfo | string>();        // Cache that stores the source file and version info
+        let missingFilePathsRequestedForRelease: Path[];                    // These paths are held temparirly so that we can remove the entry from source file cache if the file is not tracked by missing files
 
         watchingHost = watchingHost || createWatchingSystemHost(compilerOptions.pretty);
         const { system, parseConfigFile, reportDiagnostic, reportWatchDiagnostic, beforeCompile, afterCompile } = watchingHost;
@@ -274,8 +275,7 @@ namespace ts {
         const resolutionCache = createResolutionCache(
             fileName => toPath(fileName),
             () => compilerOptions,
-            () => clearExistingProgramAndScheduleProgramUpdate(),
-            (fileName, callback) => system.watchFile(fileName, callback),
+            watchFailedLookupLocation,
             s => writeLog(s)
         );
 
@@ -310,6 +310,19 @@ namespace ts {
 
             // Update watches
             missingFilesMap = updateMissingFilePathsWatch(program, missingFilesMap, watchMissingFilePath, closeMissingFilePathWatcher);
+            if (missingFilePathsRequestedForRelease) {
+                // These are the paths that program creater told us as not in use any more but were missing on the disk.
+                // We didnt remove the entry for them from sourceFiles cache so that we dont have to do File IO,
+                // if there is already watcher for it (for missing files)
+                // At that point our watches were updated, hence now we know that these paths are not tracked and need to be removed
+                // so that at later time we have correct result of their presence
+                for (const missingFilePath of missingFilePathsRequestedForRelease) {
+                    if (!missingFilesMap.has(missingFilePath)) {
+                        sourceFilesCache.delete(missingFilePath);
+                    }
+                }
+                missingFilePathsRequestedForRelease = undefined;
+            }
 
             afterCompile(host, program, builder);
             reportWatchDiagnostic(createCompilerDiagnostic(Diagnostics.Compilation_complete_Watching_for_file_changes));
@@ -446,8 +459,14 @@ namespace ts {
             // remove the cached entry.
             // Note we arent deleting entry if file became missing in new program or
             // there was version update and new source file was created.
-            if (hostSourceFileInfo && !isString(hostSourceFileInfo) && hostSourceFileInfo.sourceFile === oldSourceFile) {
-                sourceFilesCache.delete(oldSourceFile.path);
+            if (hostSourceFileInfo) {
+                // record the missing file paths so they can be removed later if watchers arent tracking them
+                if (isString(hostSourceFileInfo)) {
+                    (missingFilePathsRequestedForRelease || (missingFilePathsRequestedForRelease = [])).push(oldSourceFile.path);
+                }
+                else if (hostSourceFileInfo.sourceFile === oldSourceFile) {
+                    sourceFilesCache.delete(oldSourceFile.path);
+                }
             }
         }
 
@@ -471,11 +490,6 @@ namespace ts {
             scheduleProgramUpdate();
         }
 
-        function clearExistingProgramAndScheduleProgramUpdate() {
-            program = undefined;
-            scheduleProgramUpdate();
-        }
-
         function updateProgram() {
             timerToUpdateProgram = undefined;
             reportWatchDiagnostic(createCompilerDiagnostic(Diagnostics.File_change_detected_Starting_incremental_compilation));
@@ -547,6 +561,24 @@ namespace ts {
             }
         }
 
+        function watchFailedLookupLocation(failedLookupLocation: string, containingFile: string, name: string) {
+            return host.watchFile(failedLookupLocation, (fileName, eventKind) => onFailedLookupLocationChange(fileName, eventKind, failedLookupLocation, containingFile, name));
+        }
+
+        function onFailedLookupLocationChange(fileName: string, eventKind: FileWatcherEventKind, failedLookupLocation: string, containingFile: string, name: string) {
+            writeLog(`Failed lookup location : ${failedLookupLocation} changed: ${FileWatcherEventKind[eventKind]}, fileName: ${fileName} containingFile: ${containingFile}, name: ${name}`);
+            const path = toPath(failedLookupLocation);
+            updateCachedSystem(failedLookupLocation, path);
+
+            // TODO: We need more intensive approach wherein we are able to comunicate to the program structure reuser that the even though the source file
+            // refering to this failed location hasnt changed, it needs to re-evaluate the module resolutions for the invalidated resolutions.
+            // For now just clear existing program, that should still reuse the source files but atleast compute the resolutions again.
+
+            // resolutionCache.invalidateResolutionOfChangedFailedLookupLocation(failedLookupLocation);
+            program = undefined;
+            scheduleProgramUpdate();
+        }
+
         function watchMissingFilePath(missingFilePath: Path) {
             return host.watchFile(missingFilePath, (fileName, eventKind) => onMissingFileChange(fileName, missingFilePath, eventKind));
         }
diff --git a/src/harness/unittests/tsserverProjectSystem.ts b/src/harness/unittests/tsserverProjectSystem.ts
index b7c71f28191..39776e379c9 100644
--- a/src/harness/unittests/tsserverProjectSystem.ts
+++ b/src/harness/unittests/tsserverProjectSystem.ts
@@ -335,7 +335,8 @@ namespace ts.projectSystem {
             checkFileNames("inferred project", project.getFileNames(), [appFile.path, libFile.path, moduleFile.path]);
             const configFileLocations = ["/a/b/c/", "/a/b/", "/a/", "/"];
             const configFiles = flatMap(configFileLocations, location => [location + "tsconfig.json", location + "jsconfig.json"]);
-            checkWatchedFiles(host, configFiles.concat(libFile.path, moduleFile.path));
+            const moduleLookupLocations = ["/a/b/c/module.ts", "/a/b/c/module.tsx"];
+            checkWatchedFiles(host, configFiles.concat(libFile.path, moduleFile.path, ...moduleLookupLocations));
         });
 
         it("can handle tsconfig file name with difference casing", () => {
diff --git a/src/server/editorServices.ts b/src/server/editorServices.ts
index d617bdb2b9e..bf255c7defa 100644
--- a/src/server/editorServices.ts
+++ b/src/server/editorServices.ts
@@ -247,7 +247,8 @@ namespace ts.server {
         WildCardDirectories = "Wild card directory",
         TypeRoot = "Type root of the project",
         ClosedScriptInfo = "Closed Script info",
-        ConfigFileForInferredRoot = "Config file for the inferred project root"
+        ConfigFileForInferredRoot = "Config file for the inferred project root",
+        FailedLookupLocation = "Failed lookup locations in module resolution"
     }
 
     /* @internal */
diff --git a/src/server/project.ts b/src/server/project.ts
index c2fab978931..e600c3796e6 100644
--- a/src/server/project.ts
+++ b/src/server/project.ts
@@ -217,8 +217,7 @@ namespace ts.server {
             this.resolutionCache = createResolutionCache(
                 fileName => this.projectService.toPath(fileName),
                 () => this.compilerOptions,
-                () => this.markAsDirty(),
-                (fileName, callback) => host.watchFile(fileName, callback),
+                (failedLookupLocation, containingFile, name) => this.watchFailedLookupLocation(failedLookupLocation, containingFile, name),
                 s => this.projectService.logger.info(s),
                 (primaryResult, moduleName, compilerOptions, host) => resolveWithGlobalCache(primaryResult, moduleName, compilerOptions, host,
                     this.getTypeAcquisition().enable ? this.projectService.typingsInstaller.globalTypingsCacheLocation : undefined, this.getProjectName())
@@ -235,6 +234,23 @@ namespace ts.server {
             this.markAsDirty();
         }
 
+        private watchFailedLookupLocation(failedLookupLocation: string, containingFile: string, name: string) {
+            // There is some kind of change in the failed lookup location, update the program
+            return this.projectService.addFileWatcher(WatchType.FailedLookupLocation, this, failedLookupLocation, (__fileName, eventKind) => {
+                this.projectService.logger.info(`Watcher: FailedLookupLocations: Status: ${FileWatcherEventKind[eventKind]}: Location: ${failedLookupLocation}, containingFile: ${containingFile}, name: ${name}`);
+                if (this.projectKind === ProjectKind.Configured) {
+                    (this.lsHost.host as CachedServerHost).addOrDeleteFileOrFolder(toNormalizedPath(failedLookupLocation));
+                }
+                this.updateTypes();
+                // TODO: We need more intensive approach wherein we are able to comunicate to the program structure reuser that the even though the source file
+                // refering to this failed location hasnt changed, it needs to re-evaluate the module resolutions for the invalidated resolutions.
+                // For now just clear existing program, that should still reuse the source files but atleast compute the resolutions again.
+                // this.resolutionCache.invalidateResolutionOfChangedFailedLookupLocation(failedLookupLocation);
+                // this.markAsDirty();
+                this.projectService.delayUpdateProjectGraphAndInferredProjectsRefresh(this);
+            });
+        }
+
         private setInternalCompilerOptionsForEmittingJsFiles() {
             if (this.projectKind === ProjectKind.Inferred || this.projectKind === ProjectKind.External) {
                 this.compilerOptions.noEmitForJsFiles = true;