Watercolor was the alternate name for the new "Professional Theme" that shipped with the pre-beta versions and beta 1 of Windows XP, which at the time was code-named Whistler.
Although Whistler initially sported the original, Windows 95 to Me interface, Microsoft realized that it faced competition not only from its long-time rival Apple, but from Linux and XFree86; the ability to not only pick one's window manager but to pick what it would look like, down to the finest detail, was a very appealing option to users, and the blues and greys of Microsoft's Windows weren't going to cut it any longer.
Watercolor first shipped to external testers in build 2257, which was built August 10, 2000. Though the prior build, 2250, included the "Professional Theme" as well, it was not Watercolor, but instead a two-tone replacement for the original interface. Instead, this new Watercolor theme was a combination of light blues and off-whites, with a switch to Arial and Tahoma for most system fonts. The general idea was to replace all grey with off-whites, and to replace any window title bars or borders with the blues. In addition, all menus that were previously highlighted with the typical Windows dark blue were replaced with a lighter blue, giving a more transparent feel. The mood of the theme was akin to Office 2000, and more to the point, Office XP, which was later released looking very similar to Whistler. The idea seemed to be "flat and smooth," meaning all window controls were to be flat, and should only have their presence felt when activated by the mouse.
It is worth noting that the community of beta testers for Whistler welcomed this new theme with more than open arms; to this day it is still viewed as a very visually appealing and simplistic theme. What I find odd about this is that aside from the "flat and smooth" look it presented, the only real change how the gradient looked on the window title bars; rather than slowly fading from one color to the next, the toolbar was bitmapped to show a light, sky blue pixellating into a darker blue.
Same old gradient, just different colors, magnified 900%.
Jast after the start of January 2001, Microsoft released build 2419 of Whistler, the last publicly available build of Whistler that would have the Watercolor interface. Beta 2 of Whistler, by that time rebranded as Windows XP, would instead ship with the new "Luna" interface, a big, bright jumble of blues and greens designed to catch the attention where the nearly monochromatic MacOS X may have failed. Many regarded this new theme as too child-like, and wished for the Watercolor theme to return. Unfortunately, the Watercolor theme had been brushed off of Microsoft's plate, and so had the idea of skinning; rather than pursue the hearts of those who were open to the idea of changing to Windows interface, Microsoft instead chose to attempt to keep their platform unified with a single look, the One Microsoft Way.
The reasons cited behind Microsoft's decision were that they were afraid of issues arising from people using unconventional themes, namely those that would prevent text and telephone support from being able to adequately support an end-user. In addition, Microsoft didn't want poorly written themes affecting system stability, and to this end they wrote their code to require that all themes be digitally signed with a Microsoft key.
Shortly after the release of Windows XP in October 2001, a company known as TGTSoft released software called Style XP, software which cracked the file uxtheme.dll, the file responsible for checking the signature for themes. With the checking for the signature removed, skinners were able to begin creating skins, thanks in no small part to TGTSoft's later released StyleBuilder, which was created to aid in skinning every skinnable portion of Windows XP.
Within weeks of the program's release, many users had managed to recreate the sought-after Watercolor theme, using old copies of Windows Whistler. Because of the efforts of those people, the once-abandoned Watercolor theme from Microsoft is now welcome option for use in Windows XP, among many other themes.
To take a peek at the Watercolor theme, as Microsoft originally had it, take a look here: { http://www.winsupersite.com/images/reviews/2410per_0011.gif }
It's nice to see what a few determined individuals can do, even when the Redmond Giant has dismissed it as not worthwhile.