It seems if you place the lily pad by clicking the wall next to the water source then it drops the water level by one block but if you click on the surface of the water aiming downwards then it places the lily pad on the surface of the water.
Added a screenshot. If, after having removed the lilypad on the screenshot, you put the lilypad above purple line->water breaks, below purple line->lilypad correctly placed. Only works on edge water blocks if the water is at least 2 block deep.
I don't know if this was mentioned before, but it happens every time when you point at a block that is next to the water. Either at the little bit that's visible above water or the rest below.
It seems if you place the lily pad by clicking the wall next to the water source then it drops the water level by one block but if you click on the surface of the water aiming downwards then it places the lily pad on the surface of the water.