thanks for the responses -
a question - which OS are you using - XP/Vista/7.....?
and also, where is your game folder located on your HD?
i ask, because if it's inside Program FIles folder, you will have this kind of problem.....
if it's the case, i recommend MOVING your entire install to a location outside of Prog Files... 
I'm running Vista x64, but I have my game at c:\IL2...
Did you select OpenGl (Yeah I know you sure you did but check it once again), if you have selected OpenGl make sure water=3 is in section for OpenGl and not DirectX in conf.ini.
Make sure your terrain is in perfect mode and that after setting water=3 in conf.ini you dont use settings in game.
I even added a line for water = 3 in the Directx section, and tried running both openGL and Directx, but I can't see any difference.
oh, and I forgot to put the conf file back to "read only, and sure enough, after running, it was changed back to a 1:
[Render_DirectX]
TexQual=3
TexMipFilter=2
TexCompress=0
TexFlags.UseDither=1
TexFlags.UseAlpha=0
TexFlags.UseIndex=0
TexFlags.PolygonStipple=1
TexFlags.UseClampedSprites=0
TexFlags.DrawLandByTriangles=1
TexFlags.UseVertexArrays=1
TexFlags.DisableAPIExtensions=0
TexFlags.ARBMultitextureExt=1
TexFlags.TexEnvCombineExt=1
TexFlags.SecondaryColorExt=1
TexFlags.VertexArrayExt=1
TexFlags.ClipHintExt=0
TexFlags.UsePaletteExt=0
TexFlags.TexAnisotropicExt=0
TexFlags.TexCompressARBExt=1
TexFlags.TexEnvCombine4NV=0
TexFlags.TexEnvCombineDot3=0
TexFlags.DepthClampNV=0
TexFlags.SeparateSpecular=0
TexFlags.TextureShaderNV=0
HardwareShaders=0
Shadows=2
Specular=2
SpecularLight=2
DiffuseLight=2
DynamicalLights=1
MeshDetail=2
VisibilityDistance=3
Sky=2
Forest=2
LandShading=3
LandDetails=3
LandGeom=2
TexLarge=1
TexLandQual=3
TexLandLarge=1
Water=3
VideoSetupId=4
ForceShaders1x=0
PolygonOffsetFactor=-0.15
PolygonOffsetUnits=-3.0
[Render_OpenGL]
TexQual=3
TexMipFilter=2
TexCompress=0
TexFlags.UseDither=1
TexFlags.UseAlpha=0
TexFlags.UseIndex=0
TexFlags.PolygonStipple=1
TexFlags.UseClampedSprites=0
TexFlags.DrawLandByTriangles=1
TexFlags.UseVertexArrays=1
TexFlags.DisableAPIExtensions=0
TexFlags.ARBMultitextureExt=1
TexFlags.TexEnvCombineExt=1
TexFlags.SecondaryColorExt=1
TexFlags.VertexArrayExt=1
TexFlags.ClipHintExt=0
TexFlags.UsePaletteExt=0
TexFlags.TexAnisotropicExt=1
TexFlags.TexCompressARBExt=1
TexFlags.TexEnvCombine4NV=1
TexFlags.TexEnvCombineDot3=1
TexFlags.DepthClampNV=1
TexFlags.SeparateSpecular=1
TexFlags.TextureShaderNV=1
HardwareShaders=0
Shadows=2
Specular=2
SpecularLight=2
DiffuseLight=2
DynamicalLights=1
MeshDetail=2
VisibilityDistance=3
Sky=2
Forest=2
LandShading=3
LandDetails=3
LandGeom=2
TexLarge=1
TexLandQual=3
TexLandLarge=1
Water=1 <--------!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! this was a 3!!!!!!!!!!!!!!!!!!!!
VideoSetupId=3
Effects=1
ForceShaders1x=0
PolygonOffsetFactor=-0.15
PolygonOffsetUnits=-3.0
I took some screenshots - how do I attach them?