Step 1: Reaction principle.
Benzene diazonium chloride (C$_6$H$_5$N$_2$Cl) when heated with water undergoes hydrolysis to give phenol, nitrogen gas, and hydrochloric acid.
Step 2: Reaction.
\[
C_6H_5N_2Cl + H_2O \xrightarrow{\Delta} C_6H_5OH + N_2 + HCl
\]
Step 3: Analysis of options.
(A) Benzene: Not formed here.
(B) Benzyl alcohol: Incorrect product.
(C) Phenol: Correct, formed as the major product.
(D) Chlorobenzene: Obtained with CuCl (Sandmeyer’s reaction), not by hydrolysis.
Step 4: Conclusion.
Thus, the correct answer is (C) Phenol.