What makes this story historical fiction, what part of history was fictional?
"Historical fiction" simply refers to books and films that, while involving fake characters and a made-up story, take place during events that actually occurred. Books and films that use that approach have always been popular with the public, and will no doubt always be produced.
A classic example of historical fiction were the book and film "Gone with the Wind." While taking place during the period of the American Civil War, the story itself is fictional, and the characters completely made-up. Another good example was the film "Saving Private Ryan," which involved fictional characters on a fictional mission during a war that definitely existed.
Such is the case with "Stones in Water." Donna Jo Napoli constructed her story of boys, one with a dangerous secret that, if discovered, could get him killed, in wartime Italy, with the horrors of the Holocaust providing a foreboding backdrop. The war and the Holocaust certainly existed, but the story and characters are fiction.