Motorcycle Repair: ATV OIL, polaris sportsman 700, polaris sportsman 700 twin

Question
I have a Polaris Sportsman 700 twin.  I took the atv to my local dealer for oil leak and clanking noise in the engine area.  After they broke the bike down they are claiming that it was full of water which broke down the oil which in turn caused damage to the engine.  The crank and rod bearings are shot.  The part that I question is that I know that I have not submerged the bike under water nor should there be any water in the oil what so ever.  The reason they state that I did not detect the water in the oil is that the water and the oil had separated and all of the "milky oil substance" was in the bottom of the crank case.  They say that this is the reason I did not detect this on the dipstick when checking for this.  MY QUESTION: Once a substancial amount of water is introduced into the oil and mixed thouroughly up together, have you ever seen this separate back out into two parts in an engine.  The bike has 500 miles on it and is shot at this point.  Thanks for any insight for the water/oil issue.

Answer
I only work on harleys, but I think I can help you.
Once water is introduced into the oil it will foam when the bike is running and turn a brown color. Once you stop the bike, over time it will seperate. I can't tell you how long it takes. Its like oil and vingar dressing. Shake it well and it will mix. Let it set and it will seperate. One thing though that you should notice. You can usually see water droplets on the dipstick.
What puzzles me is where the water came from, since you stated that you have not submerged the bike. I too have a 4 wheeler and I work on it myself. The only places where the water can enter the engine is through either the exhaust or the intake.
I think if it was me I would ask to see the oil that came out of the bike to check it yourself. Also check the parts. If there was all that water they should have some rust on them.
Mike