I managed to prosecute a successful war against R'lyeh as T'ien Ch'i in the Faerun PBEM. Here's some tips.
1.) Construction is even more important than usual when fighting an underwater opponent. Getting your mages underwater is vital to win those decisive battles.
2.) Don't neglect getting your sneaky units underwater. Spies with breathing items can wreak havoc, and you'll need underwater scouts with gems to keep your underwater mages supplied.
3.) School of Sharks and Shark Attack (both Conjuration) will give you loads of free chaff.
4.) Set the taxes to 200% on every underwater province that you're not *certain* of holding (especially forts you're sieging). In the short term, you'll get more money, and in the long term the province will become useless for the enemy, again to your advantage. Similarly, don't be afraid to demolish underwater forts which come into your possession; remember that they're far more valuable for the underwater nations.