Jason Kottke did a little research on just that query and the while the jury is still out, the possible theories are all plausible.
He says," When I was in London a couple of weeks ago, a group of us was sitting around in a pub on Saturday afternoon (what a cliché!) and someone mentioned that the reason that the English "loo" is so named because the toilet was commonly located in room 100 of buildings and the two ("loo" and "100") look very much the same."
He also unearthed the following other possibilities:
When people flung their potty waste out of the window, they would shout "Gardez l'eau" [gar-day low]. That's French for "watch out for the water". - History of Loos
"The word appears to originate no earlier than James Joyce's usage in Ulysses in 1922 -- "O yes, mon loup. How much cost? Waterloo. water closet." -- perhaps Joyce came up with it. Or it could be "a British mispronunciation of the French le lieu, "the place", a euphemism." - Michael Quinion
"It's short for "Lady Louisa," Louisa being the unpopular wife of a 19th-century earl of Lichfield. In 1867 while the couple was visiting friends, two young wiseacres took the namecard off her bedroom door and stuck it on the door of the bathroom. The other guests thereafter began jocularly speaking of "going to Lady Louisa." In shortened form this eventually spread to the masses." - Cecil Adams
Kottke wraps up: "But Adams has no definitive answer either and so the question of the etymology of loo will continue to be debated on the Internet and in pubs around the world."