The term comes from the hammer action on a gun. The hammer dropping on many pistols is what causes them to fire. If you "drop the hammer" on somebody, you go all out.
When someone raises early (usually pre-flop if playing Holdem) just to push other players around, and you just can't take that smug grin on his face, you re-raise a ridiculous amount and "drop the hammer." This most often occurs during a Testosterone Fight, and the object is to make the other player put his testosterone hose away and fold. Since it is pre-flop, this has nothing to do with the cards you have, just plain good ol' fashioned balls.
Ryan: I call.
Mike: I call.
Kevin: I call.
Marco: I call.
Matt: I call.
Dana: I call.
Devin: I call.
Dave: Well... I'll just double the blinds so I have even stacks... mwaahaahahaa...
Devin: Fuck that! I'm DROPPING THE HAMMER! All in, bitch!
Sam: Coooold bloooooded.....