OP here with an update......
I took the Ipod Touch to
Best Buy this afternoon and went through the expected drama. BB does cover water damage, not immersion, but things like spilling water on it or rain damage is covered. They couldn't decide if it was the water or the drop, there was evidence of both, but the sensors were not red(the ones they could see). They agreed it was covered under the accidental coverage included in the warranty I purchased.
The drama started because since I bought the IT in August, a new generation came out. The GeekSquad guy was saying it had to be replaced by the same exact IT. In order to do that, they had to do something called an "advance replacement", or at least I think that's what it was called. Basically, a new device is sent out from the warehouse. Well, the guy said they were backordered(no duh, they are the old generation now) and it could be weeks to months before we got the new one.
So...I told him that wouldn't work. I was told when I bought the warranty that if something happened to the IT, we could come in and get a new one on the spot. I asked him why we couldn't just get the new generation, and he said they couldn't do that because it was more money. So, I offered to pay the difference, since DS would love the new features. That was not an option either. They finally gave it to a manager, who said the same thing. Then he went on the computer to see if he could figure out how long the backorder would take. Well, lo and behold, he said the screen said there was an option of a substitute. He went and got a new generation IT and told the customer service person to do an exchange.

The guy rang it up and the new one is actually $30 cheaper than the old one. This also made the warranty price go down(warranty is now updated to end in 11/2011) and I got a gift card for $41 on top of the new Ipod.
Moral of the story is stand your ground and they will honor the warranty.
Marsha