Wet sanding drywall is a common method that is used to smooth the surface of the drywall compound. It really isn't sanding at all. Instead a sponge or rag is used to dissolve the drywall compound.
For related drywall taping and finishing information see the articles 'Taping and Mudding Drywall', 'How To Patch Drywall' and 'Fixing Holes in Walls and Ceilings'.
Advantages of Wet Sanding
This method has some advantages. The first would be that it does not require any special tools. A sanding block and a rag or a sponge along with a pail of water are all the tools that are needed. Done carefully, this method can yield a smooth surface that is ready for paint. The biggest advantage to wet sanding drywall is that there is no dust at all. All the excess drywall compound is dissolved by the water and winds up in the pail of water. Great!
Drawbacks to Wet Sanding Sheetrock
Wet sanding drywall does have some drawbacks. First the feathering of the edges is not quite as smooth as regular sanding. This may or may not be noticeable after the patch is painted. Second, it is very easy to remove too much compound. When this happens you are forced into coating the area again. Lastly, you can groove the surface without realizing it. Again, when this happens you will have to coat the area again.
How To Wet Sand Drywall
Always use something that is flat and fairly stiff for this method. Never use just a rag and your fingers to finish the drywall. You will groove it almost immediately. They do sell sponges at drywall and home supply stores for this purpose. They are not expensive and work pretty well. Use a damp sponge, not soaking wet. Wring it out often while you are smoothing the surface. Make several light passes and do not put too much pressure on the sponge.
Another option for this type of dustless drywall sanding would be a sanding block and a rag. The same principles apply, not too much water and light pressure. Don't try to do too much with each pass. Don't remove too much compound.