Fluid on the knee, also called "effusion" or water on the knee, is when the knee joint has experience injury or trauma, and is reacting by swelling and flooding the area with bodily fluids to try and protect the injured area. The swelling can be nominal, or grotesquely huge, and treatment for it will largely depend on how bad the swelling is.
The first, and simplest method, to reducing swelling of the knee, is to apply the ICE method. (I)ce, (C)ompress and (E)levate. Prop the injured knee up to a height above waist level, then apply an ice-pack to the joint for at least twenty minutes. Be sure and place a thin cloth between the ice pack and your skin to avoid frostbite. Keep the knee elevated throughout treatment, and then wrap the knee in a compression bandage, such as an Ace Bandage, after treatment, to provide support for the knee until it heals. This method is very successful in most cases.
Use NSAID's (Non-steroidal Anti-Inflammatory Drugs) such as Tylenol, Advil, Aleve or Aspirin. These drugs were made to reduce swelling and stiffness, and when combined with the above treatment can prove highly successful at reducing most cases of fluid on the knee. Be sure and check with your doctor about dosage and side-effects of these drugs. Use common sense and rest the injured knee. Stay off it, and do not attempt anything other than basic mobility until the fluid is reduced.
If the above treatments have no result, or if the knee joint is grotesquely swollen to the point that bending the joint is compromised, then you need to seek medical attention. In the cases of severe fluid on the knee, aspiration will be done to remove the fluid. This procedure is when a large needle is inserted into the knee joint, and the area manipulated until as much of the fluid as possible has been removed. Although uncomfortable, it is a quick solution to the immediate problem, and the fluid can then be checked to make sure there is no infection to the knee joint.