The “water sensor” actually appears to be a piece of litmus paper, placed in such a way that allows Apple to determine if your iPod has been damaged by moisture (and therefore not covered under warranty.) This is not uncommon, apparently, for consumer electronics.

But, since the paper is so conveniently placed inside the headphone port, I can’t imagine it would be too difficult to change the paper back to its original color with a Q-Tip and some household acids and bases.