The practice of mixing water and wine was common in the ancient world. Wines were usually heavier than most modern vintages, and to dilute them a bit made them more palatable and less inebriating. People also drank more wine since water in the ancient world could not be purified easily as is done today. Thus, the wine used at Mass was mixed with water before the consecration in the usual manner of all wine. 
 
Mystically it came to represent our inclusion into Christ's Body by our baptism. The priest says: "By the mystery of the water and wine, may we come to share in the divinity of Christ who humbled himself to share in our humanity". 
 
Though the practical reason to mix water and wine no longer is needed, it still remains a powerful symbol and so its practice remains.

As you rightly point out, fornication (premarital sex) is a very serious sin, which has sadly received widespread acceptance in our culture. The related sin and trend of cohabitation makes matters even worse because of its public nature and capacity to give scandal. Scripture in many places describes the sin of fornication as a mortal sin, declaring that it excludes one from the kingdom of heaven (for example Ephesians 5:5, one Corinthians 6:9, Galatians 5:21, among others). 
 
God consistently condemns fornication because of the harm it does the human person, the sacrament of holy matrimony, and children. Children conceived of fornication are at high risk for abortion since 85 % of abortions are performed on single women. If they survive this risk, they are still likely to be raised in irregular situations that are not best for them. This in turn leads to many other social ills. 
 
Consequently, fornicators not only sin against God's gifts of marriage and sexuality, but also sin against justice by engaging in behaviors that harm society and children. 
 
What then is a priest to do when he prepares couples for marriage who are often cohabiting? Of course there are many prudential factors involved. At least the couple is trying to set things right. Having them seek separate domiciles is best but not always feasible. But surely every priest ought to teach such couples of the seriousness of their sin and insist they live chastely and sleep in separate rooms. While he cannot enforce this, he ought to instill in them a holy reverence for God who sees all things. 
 
In order to avoid scandal that is easily given by cohabiters who cannot separate, many priests make some mention at the wedding of the fact that he instructed the couple to live chastely and was glad that they were willing to give heed to the holy instruction of God. He can be discrete but clear, and even use a little humor. But simply ignoring the issue altogether when a couple has publicly cohabited offends against the common good by giving the impression that such behavior is good or no big deal. Silent pulpits are a sadly common source of scandal.