Final answer:
Magic realism is displayed in the story 'Handsomest Drowned Man' through the growth of the drowned man's body as the villagers care for it.
Step-by-step explanation:
Magic realism is a literary genre that blends fantastical elements with realistic detail. In the story 'Handsomest Drowned Man,' an example of magic realism is seen when the drowned man's body grows larger and more beautiful as the villagers care for it (option 1). This fantastical element of his body growing contradicts the laws of nature but is described in a realistic and detailed manner. The other options, such as the villagers believing he is a supernatural being (option 2), the drowned man coming back to life (option 3), and the villagers holding a funeral for him (option 4), do not represent magic realism as they involve purely supernatural or realistic events without the blending of the fantastical and the ordinary.