Water Candles increase the monster spawn rate by 33% and increase the maximum number of spawned monsters by 50%, but only when held in your hand. Merely having it in your inventory or set up in your house doesn't do anything.
The Water Candle was broken before the 1.0.4 update, though; its effect was instead attributed to the Band of Regeneration. This is no longer the case.
From the disassembly (
if (Main.player[index3].inventory[Main.player[index3].selectedItem].type == 148)
NPC.spawnRate = (int) ((double) NPC.spawnRate * 0.75);
NPC.maxSpawns = (int) ((double) NPC.maxSpawns * 1.5);
spawnRate means higher probability of monster spawns.)
After patch 1.2 placed candles also affect spawnrates: (from disassembly)
NPC.spawnRate = (int)((double)NPC.spawnRate * 0.75);
NPC.maxSpawns = (int)((float)NPC.maxSpawns * 1.5f);