It is when the battery case is breached and the contents contact water. Search Youtube for “lipoly fire” or similar and you will see dramatic (and scary) examples. The different lithium battery chemistries do vary somewhat in their propensities to catch fire (looks like an explosion).
The proper way to dispose is to totally discharge the battery (to about zero volts) and then discard in trash. The discharge can be accompished by running leads from the postive and negative terminals into salt water and leaving for about ten days.