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Typically applied to online regularly-changed/updated video games.

To "nerf" something means to reduce its 'power' or effectiveness within the game. Often times this is to solve some problem in the game (such as an 'overpowered' weapon/ability or super effective strategy), or to push the players in one direction or another (such as a new cosmetic/item/character).

Nerfs affect the 'meta' or prevailing strategy/characters/items used to win the game. In this way nerfs also give control to the developer of how the players play the game. i.e. nerfing a commonly used item to discourage the community from playing with it.

Some nerfs can be so drastic they change the very fundamentals of the game, and are often a contributing factor to the size of the playerbase, for good or bad.

Outside of games, this would again mean to reduce the things 'power' or 'effectiveness'. The exact analogy that gave birth to this term, is that of a Nerf Gun, compared to a real gun.
Oh man, they totally nerfed 'Titans Armor'! Guess I'll stop playing Golem now :/

They nerfed Irelia again?? Oh wait, its actually a buff. <-- (opposite of nerf)

Great, so now all the free-2-play guns are nerfed, guess I have to buy some to keep competitive. :(
Related Words
The term "nerfing" comes from the online gaming world of Ultima Online.

At one point in the game, the developers reduced the power of swords in melee combat.

This resulted in players complaining that it was like they were hitting each other with nerf bats, not swords.

From then on, if ever something gets made less worth while than it had been originally, it is considered 'nerfed'
"Oh man, they reduced the dmg on the berserker class and now it's totally nerfed!"

"Damn, the Devs nerfed those axe's real good!"
nerfed by Dave Elliott January 11, 2005
A term used when something in a game (generally an MMOG or FPS) is weakened considerably.

Nerfbat came about because Nerf creates harmless versions of harmful devices (swords, guns, etc).

When an MMORPG developer gives something the nerfbat, they often drastically reduce the effectiveness of said item.

see also: nerf
SOE has given the Sword of Demon Slaying the nerfbat; it can barely pommel a rabbit to death in its current state! - nerfbat.com
nerfbat by Adraedan January 29, 2004

nerfherder

1) A shepherd of limited intelligence caring for creatures of a limited intelligence.

2) An insult in the Star Wars trilogy.

3)A 90's band catering to fans of obscure Star Wars trivia.
Jean calls herself an administrative assistant, but she's more like nerfherder.

Leia: You're nothing but a scruffy-looking nerfherder.
Solo: Who you calling scruffy-looking?
nerfherder by paleface April 12, 2006
Darryl: (to Michael) You live a sweet, little, nerfy life. Sitting on your biscuit, never having to risk it. - The Office; Season 3, Episode 20
nerfy by ILoveTheOffice77 March 20, 2011
The act of making something worse or weaker.

The verb form of "nerf."
So I don't win too much, I'm nerfing my performance to balance the game.
Nerfing by sarroth July 2, 2011