You don't need to make this into an ego match with the water department.
I'd suggest sending a polite letter to the water department, _totally agreeing_ with their requirements, and then asking for assistance in meeting the NEC requirements at the same time (and listing the NEC requirements). I'd similarly send a polite letter to the electrical department, _totally agreeing_ with following the electrical code as adopted in your local, and asking for assistance in meeting the water department requirements (and listing them).
There are possible solutions, but it requires coordination. jwjrw mentioned one possible solution in post #2: having a plastic incoming main.
You are _not_ required to use the incoming water pipe as a grounding electrode.
However you _are_ required to use all available grounding electrodes, so if the incoming water pipe meets the criteria for a grounding electrode then you _must_ use it.
This says to me that if the water company doesn't want their pipe uses as a grounding electrode, then it must somehow be rendered unsuitable as a grounding electrode.
You _must_ bond interior metallic water piping. If the incoming water pipe is metallic, and the interior water piping is metallic, then (intentional or not) the incoming water pipe will be used as a grounding electrode unless you do something to prevent this.
The gas company folk have been dealing with this exact issue for years. The solution that they use is a 'dielectric union'. The external gas pipe is electrically disconnected from the interior gas piping. The external gas pipe is unsuitable as a grounding electrode, the interior gas piping is bonded to the electrical system. No problem.
I am sure that if the local water company is motivated, they can get what they want without creating an electrical code violation.
-Jon
