'Water-on-the-knee' should really probably be called 'fluid-in-the-knee'. The fluid is not just water, and the fluid it is IN the knee not ON it.
The knee joint cavity is lined with a membrane that produces lubricating fluid to help the smooth movement of the knee in bending and straightening. This fluid is normally like egg white, and the knee cavity normally contains a little under a teaspoon (less than 3.5 millilitres) of this fluid. It is called 'synovial fluid' and the membrane that produces the fluid is called 'the synovium' or the 'synovial membrane'.
When the knee is irritated for any reason the synovium tends to produce excessive amounts of fluid, and when the fluid is excessive it is called 'an effusion'. Doctors never use the term 'water-on-the-knee' amongst themselves - it is a term reserved for explaining things to patients. With an effusion the knee is generally swollen.
Doctors might also use the term 'water-on-the-knee' in reference to isolated pockets of excess fluid, where the synovium lining special lubricating cavities around the knee - bursae - produce excess fluid. In these cases the swelling forms discrete swellings - unlike an effusion where the swelling is generalised. Names for such discrete swellings include 'housemaid's knee', 'clergyman's knee' and other colourful descriptions.