you should be able to resize terrains to be any size, small or large without problems - worst case simply re-apply the water shader to the water surface. We have used small terrains for fountains and so on without problems - and technically if you are just looking for the visual appearance of water, you CAN apply the water surface template to any surface, terrain or otherwise.
Regarding bouyancy, you 'could' use the
ForceInfluenceArea OPR property to define your own custom 'water' zone that props the player up. All Bouyancy does is basically push the player up towards the surface, however this wouldn't work quite as well as a proper water flag like you suggested.
We've discussed doing something similar, and will probably end up adding something like this - on my list of things to do is being able to use the Road system for rivers & streams and so on, and this would require something similar as well.