(Quick Clarifier - Voya Nui is a fragment of the Southern Continent, which is inside a dome. So in the Great Cataclysm it busted up through the top of the top of that dome - so your second theory is correct.)
Some helpfully detailed concept art from Faber shows that the original plan was to show that there was, in fact, a giant waterfall falling into Karda Nui (it’s actually the one that Matoro fell through). It slowly filled up, but didn’t flood because:
- Karda Nui is massive
- The seawater, when it made contact with the water of Karda Nui, underwent a reaction that turned it into light (essentially being a light source for the dome). I can’t recall offhand if this was a reaction to the Protodermis or the Pit Mutagen.
Obviously, we didn’t get to see much of this because by '08, there was no hole for the waterfall anymore. But I believe that canonically there was a giant void where water poured into Karda Nui.
(And yes, by extention, it means that the Southern Continent would have seen this waterfall flowing right past them, an odd little detail that’s not oft-mentioned but canonically has to have happened for everything else to make sense.
I think that the Staff of Artakha (which was used roughly at the time Matoro sacrificed himself) repaired the hole in the dome that Voya-Nui busted through, though I don’t have a specific source to back that up.
tl;dr - Yes, there was a giant column of water falling from the sky, but because of where the story was set we never really got to appreciate that visual.