A.Mike Casey, a licensed plumbing contractor in California and Connecticut and coauthor of Code Check (Plumbing and HVAC) responds: Sounds like the fire marshal and the code official need to chat. In most municipalities, the building official has the final say when it comes to residential property modifications. Additionally, the codes the fire marshal cites may not be adopted in your town.
The 2000 Uniform Plumbing Code, section 1213.6, does indeed prohibit water heaters from being installed in a basement or pit where "heavier than air gas might collect and form a flammable mixture." The 2000 Uniform Mechanical Code, section 304.6, states about the same for all liquid-fuel gas appliances.
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