Going with the military origin, I always thought that a squib was a fuse (like on an old-fashioned cannon, or on a stick of dynamite), so a damp squib was something that just wasn't going to fly, or something disappointing, sometimes used in the same sense as a "wet blanket" - a downer.

AHD says:

1a. A small firecracker. b. A broken firecracker that burns but does not explode.

So a damp squib, according to b, is a damp, broken firecracker - talk about a disappointment!