May I block off all windows in a mostly below-ground basement?
From a code perspective, I think you are OK so long as the square footage of the basement is less than 200 and there is adequate ventilation.

I personally believe there is a safety concern though, but minor and something you could mitigate with ensuring smoke detectors are plentiful and fire extinguishers are readily available, but this is something people should already have.

In your case, my suggestion would be to correct the water penetration which is either poor water sealing or poor drainage in the window well.