What is the status of wine diluted with water with respect to Berachot and Kiddush on Shabbat?
Of course, all wines sold on the market have been diluted with water to some extent. What proportion of wine is required to allow using the wine for Kiddush on Shabbat, and to warrant reciting "Borei Peri Ha'gefen" rather than "She'ha'kol Niheya Bi'dvaro"?
The Gemara in Masechet Shabbat cites two views on this issue. According to one position, so long as the mixture consists of at least one measure of wine for every three measures of water, it may be used for Kiddush and it warrants the recitation of "Borei Peri Ha'gefen." The other view requires a minimum ratio of one measure of wine for every two measures of water.
The Rishonim (Medieval Halachic scholars) note that these measurements applied only to the wine used in Talmudic times, which was particularly strong, and thus required significant dilution to become suitable for drinking. Wines used nowadays, however, require far less dilution, and thus even lesser amounts of water in the wine would disqualify the wine for Kiddush and warrant reciting "She'ha'kol."
Sepharadim follow the view that if the water constitutes the majority of the diluted wine, the wine may not be used for Kiddush and it requires the Beracha of "She'ha'kol." Even if the taste of wine is retained, it nevertheless is no longer defined as "wine" for the purposes of these Halachot if the amount of water exceeds that of the wine. (Ashkenazim follow the more lenient position, that wine retains its Halachic status even if consists of water in a 6:1 ratio to the wine, provided that it tastes like wine.) Chacham Ovadia Yosef insists when inquiring into any given wine's Kashrut status that it does not contain more water than wine, so that it can be used for Kiddush and that people recite the proper Beracha of "Borei Peri Ha'gefen." This is the position of several other authorities, as well, including Rabbi Moshe Halevi (in his work Birkat Hashem, Helek 3, page 118-124) and Rabbi Mazuz of Bnei-Brak.
Summary: According to Sephardic custom, if wine is diluted with water to the point where the water constitutes the majority, it may not be used for Kiddush on Shabbat, and it requires the Beracha of "She'ha'kol," rather than "Borei Peri Ha'gefen."