Forty-one years ago, a sister and brother – Lal and Mike Waterson of the folk group the Watersons – made a record, accompanied by some of the other leading musicians of the day. On its cover was a chubby-cheeked, cheerful sun. Inside were startling, original songs about dying children, drunkenness and peculiar people – the whole package would come to be known as folk music's Sergeant Pepper.

The record was Bright Phoebus, one of British music's legendary lost records. Now recognised as a forward-thinking benchmark for the genre, it was criticised at the time for not being "folk" enough. The album was also difficult to get. Only 1,000 copies were correctly pressed in the first place, and it has never since been properly reissued, despite the family longing for it to be.

Nevertheless, Bright Phoebus has influenced many other musicians. Billy Bragg and King Creosote have covered its songs, and Arcade Fire, Richard Hawley and Jarvis Cocker are fans. This month, Hawley and Cocker are even helping perform it on the Bright Phoebus Revisited tour, organised by Lal's daughter Marry, a musician herself. Marry is also releasing a collection of Lal's unreleased music, artwork and notebooks, Teach Me to Be a Summer's Morning, that reveals even more of her mother's astonishing talent.

These have been emotional projects for Marry: Lal died in 1998, a week after being diagnosed with cancer; Mike died in 2011. "When Mum died, I couldn't go anywhere near anything at all for nearly 10 years," Marry says, speaking from the family home in Robin Hood's Bay, North Yorkshire. "I couldn't sing those songs that had been the soundtrack for my life."

But by 2007, things were getting easier. After a spring concert at the Royal Albert Hall, the Watersons put on a tribute to Lal at Cecil Sharp House, north London, the headquarters of the English Folk Dance and Song Society. Twenty-five years earlier, Bright Phoebus was recorded in its basement.

"That was how so many folk people got involved, such as [Steeleye Span's] Maddy Prior and Tim Hart, and Richard Thompson," Marry says. "Plus a delivery guy who came in at one point." She laughs – you get the sense it was one of those weeks. "They needed someone extra to sing on the chorus, so he joined in, and after a bit, said, 'Who do I give this package to?'"

Martin Carthy, who sang with the Watersons from the mid-70s, also has fond memories of that time. "It was an utterly wonderful week, loose and very anarchic, but with an iron discipline running through the whole thing." It was also the week he and Norma Waterson – Mike and Lal's sister – decided to get married.

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In fact it was Carthy who encouraged Lal to record in the first place. He first heard her songs in 1971; Norma was working in the West Indies as a DJ, so the Watersons were on hiatus. "I was just completely enthralled – they were like nothing else I've ever heard. She had this completely off-the-wall way of playing the guitar, and of harmonising … and of writing words, which had to always sound right." Never the Same, a stark ballad about a young girl being left out in the rain, made a particular impact; so did Child Among the Weeds, a song inspired by the stillborn twin sister of her son Oliver ("sing for the love of weeping and burning"). Red Wine and Promises also shows Lal's softer side, recounting a drunken night on the town ("I'm flat on my back in the rainbow rain").

At the same time, Mike had been writing songs while working as a painter and decorator, playing them to Lal during his lunch breaks. Bright Phoebus's title track came to him on his ladder; he dropped his paintbrush, ran to Lal's to write it down and got docked an hour's pay. His other songs illustrate the record's rich variety too. Danny Rose is a jaunty rock'n'roll number about a thief who shoots and steals, while The Scarecrow is a ballad laced with pagan horror.

Carthy remembers the deep frustration after the album's release. "It got one or two decent reviews, but on the folk scene, it was greeted with fury. Some people dismissed it as rubbish." Ewan MacColl and Peggy Seeger were two notable musicians who disliked it – viewing any departures from traditional music as unhelpful to the folk genre. "It was because the Watersons had revolutionised the folk scene. People were saying 'You've shown us this wonderful thing, and now you've walked away from it.'"

The album wasn't heard for other reasons too. Half of its 2,000 pressings featured off-centre holes, and then its label, Trailer, went bust. Trailer's catalogue was eventually bought by the record's original distributor, Dave Bulmer, who re-released a cheap version in 1985 on CD with little publicity but refused to release it subsequently, and on a 2007 Radio 4 documentary claimed there was little interest in it. Given the folk revival of the last decade, you question his logic – especially as original copies sell for upwards of £50.

But this summer came a new development: Bulmer died. So what happens now? "Truthfully, I have no idea," says Carthy, a little sadly. "There's talk about talking to his wife and seeing if anything can be done there, but we just have to wait and see." The record can meanwhile be heard online on YouTube; fans have also been known to download it illegally and give the Watersons the money in person.

For now though, the Revisited tour will be the only way to hear Bright Phoebus really sing. Hawley says he feels particularly honoured to be joining the whole tour, after making friends with the family while making a Radio 2 documentary. "He's one of us," Marry says. He also knew Bright Phoebus already, as his parents were folk fans. "But the music still hits me … it reduces me to a puddle of piss."

Hawley is also hugely enthusiastic about the release of Lal's lost music: of songs such as Piper's Way,"which literally stopped me in my tracks, like a truck crossing my path". Then there's Telephone Raider, which even Lal's surviving husband, George Knight, hadn't heard. "Her music is so raw and so unique, I'm so glad it's finally being heard," Hawley says, "it's a great tragedy for British music that Bright Phoebus isn't freely available. Hopefully getting everyone together to celebrate it will finally make something happen."

As for Marry, she is just happy that her mother and uncle are getting heard again – and that her mother's other ideas, lyrics and artwork are being seen. "We've got a Facebook page for the album, and seeing her little face popping up in my feed – it's very strange. And listening to her music again, it's like she's in the room with you. Her and Mike with their cups of tea, and their guitars, just like the old days, making music together. Only we're in there with them too."

• The Bright Phoebus Revisited tour begins at the Barbican, London, on 11 October, then tours to Warwick Arts Centre (12 October), Liverpool Philharmonic Hall (14 October), Brighton Dome (15 October) and Colston Hall, Bristol (16 October). Teach Me to Be a Summer's Morning is released on 21 October by Proper Records