Lag is a situation that arises when communication between the game client and your character's server is delayed. This can be caused by many things: a slow internet connection, ISP troubles, power outages, highly-populated servers, etc. When you encounter lag all forms of interaction with the game world, such as fighting, looting, and talking to NPCs, will occur erratically or not at all.
Lag typically dissipates after some time. After the lag goes away any damage caused or taken by your character will occur rapidly and other characters and mobs may appear to move very quickly. Because of this, severe lag often leads to a wipe.
A more technical disussion is available at Lag on Wikipedia.
Lag Reduction Services
Lag often occurs due to poor routing from the gamer's computer to the game server. Lag reduction services were created to solve this problem. These services are essentially fast proxy services that help improve the route game data takes to get to the game server. These services benefit many gamers who do not already have an optimal connection to the game server. The most noticeable gains will be achieved by overseas gamers who are physically quite far from the game server that they play on. These services allow you to try them out for free to test the results, but require a subscription fee if you want to use the service uninterrupted.
Some users of proxy services may experience temporary account locks or suspensions because their IP address or region will change while using the service. Obviously this is an inconvenience even though it is relatively easy to get an account unlocked. There are lag reduction services available that allow you to log into the game using your own IP address to avoid this problem. http://www.WTFast.com is an example of a service that allows you to log into the game with your own IP address.