I have heard the term applied to gemstones and extrapolated as above, but wasn't sure how the gemstone application arose. It turns out to be quite simple.I've tried the new moon tilted in the air
Above a hazy tree-and-farmhouse cluster
As you might try a jewel in your hair.
I've tried it fine with little breadth of luster,
Alone, or in one ornament combining
With one first-water start almost shining.
The clarity of diamonds is assessed by their translucence; the more like water, the higher the quality. The 1753 edition of Chambers' Encyclopedia states "The first water in Diamonds means the greatest purity and perfection of their complexion, which ought to be that of the clearest drop of water. 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 comparison of diamonds with water dates back to at least the early 17th century, and Shakespeare alludes to it in Pericles, 1607.
Heavenly jewels which Pericles hath lost,
Begin to part their fringes of bright gold.
The diamonds of a most praisèd water
Doth appear, to make the world twice rich.