What does it mean by 'it recedes following the rains'? Is 'it' referring to the 'water source'?
As their name suggests, stepwells comprise a series of stone steps descending from ground level to the water source (normally an underground aquifer) as it recedes following the rains.

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Yes, that part of the sentence means "as the water recedes."

"Recede" means to move back, or to become less.

In other words, there are steps into the well so that when there is less water, you can still get to it.