Lava

Lava is a liquid substance found at approximately 1200-2300ft deep.

Properties
Lava functions the same as Water, meaning you will begin to drown when submerged and require Flippers to swim effectively in it. It can also be transported with a Bucket.

Unlike water, contact with lava will deal 80 damage per tick to the player and light them on fire. Monsters, excluding ones that ignore walls, also take damage from lava (with the exception of the Hellbat, Lava Slime, Fire Imp, Demon, and the Demon's rarer cousin, the Voodoo Demon), but only 50. Players under the effects of Obsidian Skin Potion are immune to lava damage, but can still drown in it. Another way to combat Lava Damage is to use the Water Walking Potion. This does not keep you from taking damage, however, it keeps you from even touching the lava.

Any items more common than blue rarity that fall into lava are destroyed; the exceptions are Obsidian, Fireblossom and Fireblossom Seeds. Therefore, use caution when you are accessing your inventory near lava. Note that the midpoint of an item has to collide with lava for it to be destroyed, so shallow lava may not destroy all items. This is a useful property to keep in mind for creating monster traps, as a shallow layer will hurt monsters, but won't destroy the loot.

Lava is generated when Hellstone is mined.

After 1.0.6 update, it is impossible to place blocks in lava to make it disappear, making it rather difficult to deal with now.

Obsidian
Obsidian blocks can only be created when lava and water come into contact. This could be difficult due to the lack of water at -2100ft depths; Earthwelling is an effective way to harvest vast amounts of obsidian.

Trivia
Lava is molten rock, but the term is usually applied only when it is expelled as the result of a volcanic eruption. Lava, as found in Terraria, would typically be termed magma instead.

History

 * 1.0.6: The Lava's emitted light was reduced. Now also generated by Hellstone mining. Shallow lava hurts again.
 * 1.0.5
 * Lava will remove Grass (including Jungle Grass, Mushroom Grass, and Corruption) from dirt and mud blocks.
 * It will no longer destroy items with a blue rarity or higher.
 * Very shallow lava won't hurt players or monsters anymore.