your best bet is to just send it in to apple care and see what they do with it.
Something just seems fishy here, as I've never had a problem with getting my phone fixed and I'm on my third 2G. One was even due to water damage, but I guess there wasn't enough water to set off the water sensor on the inside.
Additionally, I'd definitely try to get your friend to go in with it and act like it is still his. Apple, like almost every company, is much more friendly to people who actually bought their products from them.
Ok cheers, I'll take your advice. Did you admit the fact that it was water damage?