Water is said to have special properties, one of which is that it burns like acid when it touches a demon. This is a very quick way of identifying whether someone has been possessed by a demon, although some demons can be powerful enough that the Holy Water doesn't affect them. Azazel wasn't effected by holy water as seen in Devil's Trap.
This is the most common accessory for the Winchester boys. It was most recently used in the season three finale "No rest for the Wicked"
The Holy Water is usually blessed by a priest.The ritual of preparing holy water is itself in form an exorcism; the priest first exorcises the salt, and then the water itself; the traditional Latin formula for exorcising and blessing the water is:
Exorcizo te, creatura aquæ, in nomine Dei Patris omnipotentis, et in nomine Jesu Christi, Filii ejus Domini nostri, et in virtute Spiritus Sancti: ut fias aqua exorcizata ad effugandam omnem potestatem inimici, et ipsum inimicum eradicare et explantare valeas *** angelis suis apostaticis, per virtutem ejusdem Domini nostri Jesu Christ: qui venturus est judicare vivos et mortuos et sæculum per ignem.
(I exorcise thee in the name of God the Father almighty, and in the name of Jesus Christ His Son, our Lord, and in the power of the Holy Ghost, that you may be able to put to flight all the power of the enemy, and be able to root out and supplant that enemy and his apostate angels; through the power of our Lord Jesus Christ, who will come to judge the living and the dead and the world by fire.)
Deus, qui ad salutem humani generis maxima quæque sacramenta in aquarum substantia condidisti: adesto propitius invocationibus nostris, et elemento huic, multimodis purificationibus præparato, virtutem tuæ benedictionis infunde; ut creatura tua, mysteriis tuis serviens, ad abigendos dæmones morbosque pellendos divinæ gratiæ sumat effectum; ut quidquid in domibus vel in locis fidelium hæc unda resperserit careat omni immunditia, liberetur a noxa. Non illic resideat spiritus pestilens, non aura corrumpens: discedant omnes insidiæ latentis inimici; et si quid est quod aut incolumitati habitantium invidet aut quieti, aspersione hujus aquæ effugiat: ut salubritas, per invocationem sancti tui nominis expetita, ab omnibus sit impugnationibus defensa. Per Dominum, amen.
(God, Who for the salvation of the human race has built your greatest mysteries upon this substance, in your kindness hear our prayers and pour down the power of your blessing into this element, prepared by many purification's. May this your creation be a vessel of divine grace to dispel demons and sicknesses, so that everything that it is sprinkled on in the homes and buildings of the faithful will be rid of all unclean and harmful things. Let no pestilent spirit, no corrupting atmosphere, remain in those places: may all the schemes of the hidden enemy be dispelled. Let whatever might trouble the safety and peace of those who live here be put to flight by this water, so that health, gotten by calling Your holy name, may be made secure against all attacks. Through the Lord, amen.)