The important thing here is determining the altitude. Note the highlighted areas - the mouse is at a certain point, the y value at the bottom is where that is, and I've set the "Water level" accordingly.
You can also trial and error, but it takes longer. You can also assign a water shaderA shader is a program or set of instructions used in 3D computer graphics to determine the final surface properties of an object or image. This can include arbitrarily complex descriptions of light absorption and diffusion, texture mapping, reflection and refraction, shadowing, surface displacement and post-processing effects. In Terragen 2 shaders are used to construct and modify almost every element of a scene. if you don't want a flat surface (and are prepared to wait)