In a broad range of applications, carbon nanotubes (CNTs) are in direct contact with a condensed-phase environment that perturbs CNT properties. Experiments show that water molecules encapsulated inside of semiconducting CNTs reduce the electronic energy gap, enhance elastic and inelastic electron-phonon scattering, and shorten the excited-state lifetime. We rationalize the observed effects at the atomistic level using real-time time-dependent density functional theory combined with nonadiabatic molecular dynamics. Encapsulated water makes the nanotube more rigid, suppressing radial breathing modes while enhancing and slightly shifting the optical G-mode. Water screens Coulomb interactions and shifts charge carrier energies and wave functions. The screening, together with distortion of the CNT geometry and lifting of orbital degeneracy, produces a luminescence red shift. Enhanced elastic and inelastic electron-phonon scattering explains line width broadening and shortening of the excited-state lifetime. The influence of water on the CNT properties is similar to that of defects; however, in contrast to defects, water creates no new phonon modes or electronic states in the CNTs. The atomistic understanding of the influence of the condensed-phase environment on CNT optical, electronic, and vibrational properties, and electron-vibrational dynamics guides design of novel CNT-based materials.