Best way to texture 3d landscape?

[LP]

2. Is there any way to make the water more transparent as it gets shallower? Like depth fog but constrained to the inside of an object...

Steve got the point there. Also, you can use one big texture with alpha-channel which gets more transparent in some areas. You can even modify this texture at run-time to reflect any changes.

3. How can I texture the islands? With one big texture plonked over the top of it? Can I access the water model at runtime and make waves? Will these waves go up and down the beaches of the islands?

First, multi-texturing would be logical step to improve the overall look of the island. Second, you can generate a model at run-time but, as always, Steve got good point there

If I WAS to go 3d, could I still draw my pritty 2d effects over the top?

This can be just as easy as if you didn't have 3D stuff at all. And if you use Asphyre (err, this is Asphyre forum right? ), it automatically provides state changes for you, so just draw 2D after 3D (or before, if you want it to appear as background for 3D scene)