"There is water in the sugar."
Honestly, this is a poor translation. It should be "C'e (with accent mark, from ci e) acqua nello zucchero." See http://italian.about.com/library/fare/blfare119a.htm
But we haven't been taught the word "ci" for "there" yet. So... it's just a poor question.
Both mean 'in the': nel = in+il: il (when a masculine word begin with a consonant) nello = in+lo: lo (when a masculine word begin with a 's' or 'z')
I tried "Ha" instead of "Ho". Wouldn't this be possible if it's someone else's water and sugar? Does the "Ho" mean that the water and sugar are mine? Or it's just the general form?
I translated this: "L'acqua è nello zucchero," and it was accepted. Honestly I had forgotten that "There is..." could also mean "I have..."
"The sugar" in italian is "lo zucchero", because it starts with a 'z'. Therefore "in the sugar" is "nello zucchero" (nello=in+lo).