Authorities would use the water to cool and divert the flow of lava to protect the fishing port of 4,000 people on Iceland's southern Reykjanes peninsula.
Residents were ordered out on November 11 after magma shifting under the Earth's crust caused hundreds of earthquakes -- a warning of a likely volcanic eruption. Thousands of smaller tremors have shaken the region since.
But in a bulletin on Wednesday evening, the Icelandic meteorological office said the probability of a sudden eruption "is decreasing every day and is considered low" due to declining magma flow and seismic activity.
Authorities said that a state of emergency in place since November 11 would be lifted on Thursday at 1100 GMT.
Grindavik residents will be allowed to return in coming days to collect belongings, a civil protection statement added.
Civil protection and European experts will assess the possibility of "using high volume pumping to cool down the lava to protect the town of Grindavik and important infrastructures," Vidir Reynisson, Iceland's Head of Civil Protection and Emergency Management, told reporters.
The method was used in 1973, when a fissure erupted just 150 metres (164 yards) from the town centre on the island of Heimaey, surprising locals at dawn.
Residents had been able to successfully slow and control the spread of lava.
"An assessment technical team will arrive in Iceland tonight or tomorrow morning and they will assist us in assessing the possibilities," Reynisson said.
Iceland is home to 33 active volcano systems, the highest number in Europe, and experiences an eruption every four or five years on average.
Grindavik is located near the Svartsengi geothermal plant, the main supplier of electricity and water to 30,000 residents on the Reykjanes peninsula, as well as a freshwater reservoir.
It is also near the Blue Lagoon geothermal spa resort, a popular tourist destination which has closed as a precaution.
Authorities have in recent days been building reinforcements around the Svartsengi plant to protect it in the event of an eruption.
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