How can I fix my water damaged iPod touch?

You should have used a hair dryer to make sure the iPod dries properly. There was still water in there because you left it to dry naturally and it must have seeped into the working of the screen. You should be able to get it fixed, because you're not the first person to have dropped it in water and I'm sure the Apple store staff know how to fix it. Just be more careful next time =)