If you are needing the water for a crafting recipe, you drag it to the crafting bowl, along with the other ingredient for the recipe. For example, if you want to make clay, you drag the red earth to the crafting bowl and drag the water to the same crafting bowl.

If you need water for a puzzle step, if the water doesn't show up when you drop a villager on the crafting hut it means that you need to complete other steps first.