White Bear,
A phase change of water from liquid to gas during combustion would absorb energy (latent heat) so this energy is no longer available to do any mechanical work. Efficiency would go down.
This same energy going into a gas will increase the pressure a lot more, so higher cylinder pressures = more work/effort available.
The reason why water vapour decreases the temperature of combustion is because it is a triatomic molecule - it has more modes that the atoms can vibrate and absorb energy that doesn't translate into pressure than a diatomic molecule such as air (N2 and O2). This is expressed as 'gamma' or the ratio of the specific heats (c_P/c_V). If you take a look at the air-standard cycle formula for the otto cycle, you'll see that thermodynamic efficiency is a function of geometric compression ratio and gamma. As you decrease gamma, (more complex molecules) you decrease the efficiency, but in doing so, you decrease the peak cylinder pressure too.
The air-standard cycle assumes you are operating at the best igniton angle and doesn't allow for any knock limiting. So you might well say that how can you increase power with water injection if you are decreasing efficiency. Well, the answer is that if you are heavily knock limited, as tends to be in a supercharged engine, then any means of increasing the ignition advance will reap you more reward than the decrease in thermo efficiency that the lower gamma/ratio of specific heats will penalise you.
The corollary of this is that when you run lean, not only are you increasing efficiency by reducing pumping work, you are increasing the gamma by having residual O2 and N2 in the combustion products during the expansion stroke, increasing the overall value of gamma.
Apologies if my explanation is a bit too theoretical!
A