"I do not drink milk, but water instead."
No. That means: "i dont drink milk, but instead of water". Does make much sense.
No, "mas" is the translation of "but". The equivalent of instead is "em vez" / "ao invés", but they're comparative terms and can't be used at the end of a sentence without an object. To make sense you would have to say either "Eu bebo água em vez de leite", or "Eu não bebo leite, mas água em vez disso" (disso is referring to leite).