Butter is a colloid. It is formed when

Colloid is the homogeneous mixture of different phases in which one substance is distributed throughout the other substance. The substance which is present in less amount is called the dispersed phase and the other substance, or we can say which is in more amount, is called dispersion medium.

So in the case of butter we all observed that in butter, the dispersed phase is water because the water is in less amount and the dispersion medium is fat because the fat is in more amount.

So butter is formed when water is dispersed in fat.

Hence the correct option is C) Water is dispersed in fat.