What does it mean when adding a little water causes oil to loose its falvour?
I imagine this means the spice in question is both fat and water soluble however it is more water soluble causing it to loose its flavor?


Without knowing the exact spice / herb / compound in question, I can't give you a definitive answer, but your hypothesis is right on the money.

I'll try not to go completely "chemistry teacher" on you, but water is often referred to as "the universal solvent" for good reason.  Given enough water, it can dissolve just about anything. (There's gold dissolved in seawater.  Not enough to be profitable to harvest, but enough to be measured.)  Just as an example: rosmarinic acid (one of the compounds - perhaps not surprisingly - found in rosemary) is classified as "slightly soluble" in water.  

If you look at the diagram of the chemical structure (that I've brought in from wiki), all those lines are shorthand for carbon-carbon bonds - which typically mean a chemical dissolves easily in oils.  

The OH groups are alcohols (but not the getting drunk kinds), which typically make it easier for a chemical to dissolve in water.  The alcohol group, the carbon between, and the double bonded oxygen combined make something called a "carboxylic acid" (hence the acid in the name).*  Carboxylic acids are also water soluble.  So we have a chemical that can dissolve in both oils and water.  



When we talk about infusing oils, the amount of the essential oils, etc that go in is usually pretty small, compared to the overall volume of the oil.  So, if you add just a little water, a chemical that is even "slightly soluble" can make the jump into the water and leave your oil sadly lacking. 

* Vinegar is acetic acid dissolved into water; acetic acid is another carboxylic acid.