Local physics around the player is doable, like Minecraft's water/lava/red stone. Some mods already add thermodynamics, magnetism, other fluids similar to the water simulation.

Real infinite physics like draing a water dam and flooding mines is CPU intensive (there are such mods too) and changes the gameplay (reversing a flood means pumping out the water). In 2D it's a lot easier and several such physics playgrounds exists (even with basic fluid physics). E.g. Phun (https://en.wikipedia.org/wiki/Phun ) and some games based on 2D physics engines like Box2D.