The Facts
Hot water heaters -- both gas and electric -- can be enclosed. However, insulation blankets are no longer recommended for hot water heaters. Each state has codes that dictate hot water heater installation. Most defer to manufacturer recommendations when it comes to space allowance for an enclosed water heater.
Specifications
Hot water heater manufacturers today recommend a minimum of 1 inch of clearance at the back and sides of a hot water heater, and 4 inches in the front for access to controls.
Considerations
The reality is that 1 inch of clearance doesn't allow much room to work, makes installing a pressure release tube difficult and may make placing a drip pan under the water heater impossible. Most, if not all, state codes require the use of a pressure release tube and drip pan to avoid water damage in the event of a pressure leak. Even with a drip pan, most state codes require venting the pressure release pipe out of the house to a safe location, usually to the yard.
Caution
If the intent is to build an enclosure around a hot water heater, caution must be exercised to assure that the water heater can be removed and replaced without demolishing the enclosure. In any case, make sure all controls and connections are easily accessed or even a minor repair can create a huge headache.