I heard that the reason it missed the fact that Toronto is in Canada is because of the overabundance of places in the United States called "Ontario." It saw Ontario, connected it to the myriad of other Ontarios, and came up with the wrong answer.
Actually, since it analyzes millions of documents with thousands of different algorithms, it's never that simple. Here's a sample of some of the evidence that could have contributed to the uncertainty.
There's a bunch of weak evidence connecting Toronto to being a US city. For example, it's search turned up something like 8 different cities in the US named Toronto. Furthermore, Toronto, Canada appears on a list of "American and Canadian cities". Toronto is also referenced in an article about fictional US presidents. However, Watson realized that all this evidence is really weak. Ordinarily it would have been ignored, but when you're not sure what the answer it, it may have provided a slight increase in confidence.
Another important point to remember is that just because the category is "US Cities" doesn't mean that the answer is always a U.S. city. For example, there was a previous round in Jeopardy where one of the US City questions had the answer "What is shuffleboard".