Lens diffraction - in summary, as you stop down a lens, it slowly becomes less sharp, due to the smaller aperture causing light scatter. Generally, this only becomes noticeable out towards the aperture extremes, f/22 and above, sometime f/16. Before that, in general, other effects play a much greater role in image quality, so much so that lens diffraction is unnoticeable.
For example - a lens wide open, at its maximum aperture, will have the least diffraction. However, many, many lenses simply aren't sharp from corner-to-corner until they are stopped down 1 or two stops. The increase in image quality is usually so great that you can't even tell that you might have lost a hair of sharpness due to diffraction.
Here, however, I unintentionally created a demonstration of lens diffraction in action.
Both these photos were shot within minutes of each other, with identical settings, lens, post processing and so on. The only difference was the first was shot at f/16, and the second at f/32.
For the record: both images were shot with a Canon 300mm F/4 L IS lens on 64mm of stacked Rayqual extension tubs. Lit with a Canon 550 EX camera left, bare, at 1/4 power, triggered with a cheapo Chinese radio slave.
F/16 - click for huge size for pixel peeping
F/32 - click for huge size for pixel peeping
As you can see, the f/32 version has lost a lot of detail. It's not usable for printing. The lens diffraction effect more than eradicated any improvement in image quality based on depth-of-field.
And this is no cheapo lens. The glass in question is a Canon 300mm F/4 L IS lens - one of their very best models. It's extremely sharp. But after looking at the dramatic degradation in quality, I have to ask - why does it go f/32?
For even more info, you can see a good set of stop-by-stop photos showing lens diffraction in action in this article at Luminous Landscapes. A full technical explanation of lens diffraction is available here.