According to ifoAppleStore, the new policy pertains to out-of-warranty incidents that would normally require the purchase of a new phone, but does so at the expense of triggering an extention of the owners two-year AT&T wireless service contract.
Customers who trade-in their water damaged phones will be given a factory refurbished model -- not a new iPhone -- and can then transfer the SIM card from their damaged handset into the refurbished device.
Apple began including liquid submersion indicators, or LSIs, in its portable products around the time it introduced its first iPhone. They irreversibly change color once they come in contact with a liquid, thereby offering the company's retail store staff and authorized repair specialists an easy way to determine if a customer caused damage to their product with liquids -- incidents that aren't covered under Apple's standard warranties.
The iPhone 3G has four LSIs, one in the headset jack, one in the dock connector, and two others located internally. Similarly, both the 13-inch unibody MacBook and unibody MacBook Pros each contain four LSIs spread across their inner chassis, diagrams of which can be seen here.
An LSI on the first-gen iPhone can be seen as the white material inside the headphone jack.
ifo speculates that Apple's policy change on water-damaged iPhones could be a means of clearing out inventory of the current iPhone 3G ahead of new models expected this summer. However, an informed commenter points out that it's more likely an easing of general policy given that offer is valid for first-generation iPhones and costs $199 regardless of the generation or capacity of the iPhone.