Actually, I think the blocky world is good enough for the application I described. Getting geometry and kinematics right is not so important for the game. I think something like Minecraft with a rudimentary thermodynamics system, statics/continuum mechanics for blocks, and mixture system for fluids (including air) would be doable. I think what would be more important is to change the crafting system from specific items to be more based on what materials you use (kinda like Tinker's construct does it).
I even think the game doesn't have to be 3D - Terraria like world would be good fit too, if done right (probably allow several different layers at each tile - like background wall, plumbing and ambient layer for fluids).
Local physics around the player is doable, like Minecraft's water/lava/red stone. Some mods already add thermodynamics, magnetism, other fluids similar to the water simulation.
Real infinite physics like draing a water dam and flooding mines is CPU intensive (there are such mods too) and changes the gameplay (reversing a flood means pumping out the water). In 2D it's a lot easier and several such physics playgrounds exists (even with basic fluid physics). E.g. Phun (https://en.wikipedia.org/wiki/Phun ) and some games based on 2D physics engines like Box2D.
Can't neglect to mention Dwarf Fortress and its 3D water physics. Of course the price is that DF will happily drop to many seconds per frame during big 'physics moments'.
I even think the game doesn't have to be 3D - Terraria like world would be good fit too, if done right (probably allow several different layers at each tile - like background wall, plumbing and ambient layer for fluids).