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It's $199 (plus tax) no matter what model iPhone.

I had to replace my 32gb a few weeks ago due to water damage.
 
Only if under warranty or extended Applecare. Of course any 3GS would still be under warranty at this time anyway.

Nope. The $199 fee is for "out-of-warranty" replacements. That applies to any replacement that is not covered by the warranty - either due to damage that isn't covered by the warranty, or due to the expiry of the warranty. However, not all forms of damage are eligible even for out-of-warranty replacement. (Examples include damage resulting from intentional misuse or unauthorized modification, or situations in which the body of the iPhone has been broken into multiple pieces.)

http://www.apple.com/support/iphone/service/faq/#warranty7
http://images.apple.com/legal/terms/repair/docs/070108a_iphone_OOW.pdf

Why would Apple do this? Firstly, they will send you a refurbished iPhone as a replacement, which is less costly to them than sending you a whole new phone. Secondly, they will refurbish the iPhone you send back to them to redistribute to somebody else, meaning that the iPhone you send back to them actually carries some intrinsic value that Apple can reclaim.

A phone that has ineligible damage, for example, one that has broken into multiple pieces, likely does not have any salvageable parts available to refurbish, so Apple isn't getting any value for the returned part - making them less inclined to offer you a discounted refurbished iPhone as a replacement.

If the damage was covered by warranty, then the replacement would be free. (Of course, water damage is not covered by the warranty, so it's always considered an out-of-warranty replacement.)
 
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