The film, which is Canada's official entry for the Oscars, stars John Abraham, Lisa Ray and Seema Biswas and examines the plight of widows forced into poverty at a temple in the holy city of Varanasi.
India's entry, Rakyesh Omprakash Mehra's "Rang De Basanti", failed to impress Academy members. The film starring Aamir Khan was a runaway success, but was slammed by some who said it promoted violence and anarchy.
But Indian hopes are still flying high with "Water" entering the race. The fate of the film, which is yet to reach Indian screens, will be decided on Feb 25.
"Water", which did well in North America, focuses on the relationship between a widow seeking to escape stifling social restrictions and a man from a lower caste who is a follower of Mahatma Gandhi.
Though it is a Canadian production, its theme is purely Indian and still relevant. Making "Water", which was the opening film of the Toronto International Film Festival in 2005, was not a cakewalk for Mehta.
Her first attempts to make the film in Varanasi in 1999 sparked protests by Hindu fundamentalists and she had to shelve the project. She took it up four years later and filmed in Sri Lanka with vital changes in the cast - with Shabana Azmi making way for Seema and Nandita Das being replaced by Lisa.
"Water" completes Mehta's trilogy of "Fire" (1996) and "Earth" (1998).
The film's nomination to the coveted foreign film list in the Oscars became possible by vital changes made by the organisers of the Academy of Motion Picture of Arts and Sciences.
This time, entries in the foreign language category were not required to be in the official language of the country submitting the film. Any language or combination of languages is acceptable as long as the principal language is not English. "Water" fitted the bill.
"That may sound like a profound change," said Academy executive director Bruce Davis in a press statement.
"But it actually addresses a situation that has cropped up only once before in our history, and may not arise again this century. Last year, the Italians wanted to submit a picture that was clearly made by Italian artists, and which qualified for the category in every other way except one: there was no Italian language in it. All the dialogues were in Middle Eastern languages."
"Water" finds place in the list along with the acclaimed "Black Book" from the Netherlands and "Volver" from Spain.
Other films in the list are "Days of Glory" (Algeria), "After the Wedding" (Denmark), "Avenue Montaigne" (France), "The Lives of Others" (Germany), "Pan's Labyrinth" (Mexico) and "Vitus" (Switzerland).