Decode the symptom first. A foreskin that balloons out with urine while the child passes water means the preputial opening is tight enough to obstruct outflow, which defines pathological phimosis, and the stem confirms preputial adhesions on top of this. The key decision is whether to observe or to intervene, and the rule is that asymptomatic non-retractility in a young child is normal and can be watched, whereas symptomatic phimosis with ballooning needs definitive treatment. The treatment that permanently corrects an obstructing fibrotic preputial ring is removal of the foreskin, that is circumcision, which both eliminates the constriction and prevents recurrence. The alternatives fall short: simply freeing the adhesions and dilating the opening tends to fail as adhesions reform; a dorsal slit is an emergency or salvage manoeuvre and is cosmetically unsatisfactory; and pure conservative observation is reserved for the asymptomatic physiological situation, which this child has outgrown given the symptoms. Therefore circumcision is the best treatment.
\[\boxed{\text{Circumcision}}\]