Friction stir processing (FSP) has been considered as a promising technique for grain refinement. In this study, two-pass FSP was conducted under water to enhance the cooling rate during processing, and a fine-grained AZ61 magnesium alloy was prepared through this method. Compared with one-pass FSP, the microstructure of two-pass FSP alloy is more homogeneous and finer, with an average grain size of 1.8 μm. Both the tensile strength and ductility of the two-pass FSP sample are improved due to grain refinement. A tensile elongation of 31.8% was achieved in the two-pass FSP sample. The microstructure evolution mechanism during the processing was discussed based on the microstructure examination.