Ella, water does take up space...in fact, I remember hearing that your fat cells, after the fat is burnt off, fill up with water because they don't like being empty (they never go away...just flatten out), then they let the water go. So for a little while after you burn off the fat, you'll be just as big, then you should lose some inches as you lose the water that was in the fat cells.
Hope that helps!
Personally, I always feel skinnier when doing P1. Something about the food you eat during that phase...