The Water Flag is used to create water in and around around other blocks. For example, the water flag is used to create water around a "Reeds" block or to fill in water around beveled walls. When painting using the Water Brush Type, you will only affect the water flag and nothing else.
The vertical depth of the water in a flagged block is set automatically. If there is any type of water above the block (i.e. either a Water Block Type or a Water Flag) it will fill the whole block. If there is no water above the block, it will only be 75% filled.