Should you be cautious about buying a home that has had a sewage leak in the past? The realtor said it was a "city water problem", but the people across the street saw us over there and advised us later of the real cause for the basement to have all the sheet rock, carpet and cabinetry missing. We also were suspicious when she said it was a city issue since we assumed the city would have rectified the problem and replace all that was damaged. This house is being sold "as is".

Well it ain't a "city water problem".

Hard to believe that a basement would be stripped of everything because of a sewage problem. Occupants would have had to be really stupid to let a sewage leak go on long enough to make it necessary to rip out everything.
Although such people do exist. A sewage leak would have been obvious unless it was a stopped up drain that backed up through the floor drains. Then a reasonable person would have stopped using water and called a plumber.

Implied in your post is that the neighbors just came over and volunteered information you a potential buyer. Why would they do that? Do they really know? Do they hate the present owners? Do they have an interest in the property?

Hire a plumber to inspect. Ask the sellers. They have to be true full to avoid liability. That is the sellers, not the real estate sales person.

If a basement has been ripped out, my first thought would be flooding.

I agree with hkstroud. I would be hesitant to buy a house that has had the entire basement finishing ripped out regardless of what the seller, the realtor or the neighbors say was the cause. If it was bad enough that they needed to rip everything out then it was really, really bad, and there's no guarantee that it wouldn't happen again.

You have to take everything agents say with a grain of salt. EVERYTHING. Don't forget, they often don't know anything about construction, and they also represent the seller.

I looked at a house for sale once (in a city) that had a major sewage problem in the basement - a broken waste pipe had been spilling raw sewage for some long time and it was absolutely disgusting, but it was in an expensive part of town so it sold immediately.