It doesn't sound like you would be charging them for damages out of their deposit in "bad faith," so I don't see why you couldn't go ahead and charge what you think is fair against the deposit. Be sure you have all your receipts, insurance info, etc. In California, if the judge thinks you acted in bad faith, you can be liable for twice the deposit, but it's rare they determine this anyway.
In my opinion, it sounds like the tenant overflowed the sink. I did this in an apartment by accident once, and the firemen came and used this big suction pump thing to remove the water. Fortunately, it was cleaned up in time and no damage was charged against my deposit.
They will probably sue you for their deposit back, but in my opinion, when you show the judge what the damage actually cost the insurance company, and you only charged the deductible, you're not going to look like some evil slum lord.
Get a statement from the inspectors who said the damage was likely an overflowed sink. Make your case that you think they messed with the garage water valve.
What the heck. I tell tenants to sue over deposits all the time. In this case, I think you should. You just want to look like a fair, reasonable person in court.
As far as their notice time frame. In California, it's 30 calendar days. It's my understanding that that is normally the law in other states, too, but in other states, landlords are allowed to put in leases the first of the month notice requirement. So check your lease and your state laws.
As far as them being able to break the lease, it depends on your state, and if you are required to "mitigate damages." In California you are, so you can only charge them for lost rent while you look for a new tenant, and any advertising costs. Here's a link that lists all state laws regarding mitigating damages:
http://dirt.umkc.edu/files/mitigationsurvey.htm
If this is too "legal" for you, google your state and "landlord mitigate damages" and you should be able to see if you can charge rent to end of lease or not. Some states actually allow this, even if you rent to someone else in the meantime.