[1] The clarity of diamonds is assessed by their translucence; the more like water, the higher the quality.
When Diamonds fall short of this perfection, they are said to be of the second or third water, &c. till the stone may be properly called a coloured one."
The phrase first water is also used more generally to refer to the highest quality or most extreme example of a person or thing, not just gemstones.
[1] The comparison of diamonds with water dates back to at least the early 17th century, and Shakespeare alludes to it in Pericles, 1607.
The diamonds of a most praisèd water doth appear to make the world twice rich.