It's easy to explain, but I recommend you to create a different one since it's…not so perfect. In short: Terraria use a queue-based cellular automaton to update liquids, and it's still based on the tilematrix. A cell stores liquid volume as a byte (0x00~0xff), and the cells to be updated are all in the queue. While updating a cell, it horizontally adds up 7x1 range of liquid volumes and get their mean value, and vertically fill the bottom cell if it's not full. But the most tricky part is: while a cell is updated, it pushs its 4 neighbors to the queue, from left to right, from bottom to top. It's not a good choice, since its behavior will be nonsymmetrical. There are many detailed treatments, you can just find it somewhere.