From the A.Word.A.Day mailing list:

first water (furst WA-tuhr) noun

  1. The highest degree of quality in a precious stone, especially diamond.
  2. The best grade or quality.
"Anne-Sophie Mutter: The German-born former prodigy was once known more for her strapless gowns and her glamor, but she has matured into a musical diamond of the first water."
Melinda Bargreen, "Strings of Success," The Seattle Times, Jan 17, 1999.

All the sources I can find says the origin of the phrase is in diamonds' quality being measured by their translucency -- the most like the clearest water, the highest-value. One source points out that oddly enough, this phrase was often used negatively: "He is a cad of the first water" meaning he was the most extreme kind of cad.

(Sources: http://www.word-detective.com/052598.html and http://www.shu.ac.uk/cgi-bin/tp_post4.cgi?=137550)

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