Anyone heard of Clonk Rage?

The game has some pretty sick water, that acts realistically without having any performance hit. Just to show off their water effects, RedWolf made a level where it continually rains and you have to make an underground and underwater base to survive, because the water level keeps rising.

Even though this is probably a necro, he's right, Clonk did have great water physics. That might be worth looking into. I don't think it was pixel based though, with the exception of scenarios with only a few drops of water.

This right here is pretty much the only way it could be reasonably handled: by just creating an area of different physics. The only problem is how to handle things when that area gets a hole in its bottom. I remember back when Oni Zanders forced invited me to play Clonk, it had a decent mixture of the "different physics zone" turning into a stream of particles when it started flowing somewhere. After they settled, they'd turn back into the single solid physics zone. If these particle drops fell into a zone, it'd basically be absorbed by the zone and the zone would increase in size.

This is the only way I can really think of doing it.