Diction refers to the specific words we choose to express our ideas. Two words can have the same dictionary meaning, but have different connotations, or shades of meaning.
For instance, a believer might speak either of "God" or "the Lord." Both words indicate the same referent, but the meanings are different. "Lord" implies a rather distant, potentially authoritarian, master-servant relationship. "God" does not.
William Blake could have chosen to refer to God as "the Lord" in this poem, but he did not. His diction contributes to a more immediate and intimate picture of God—someone who is "ever nigh" (close) and who appears like the boy's own father.
What can we say about the diction of the entire poem? Some of the word choices—like that "nigh"—might seem literary or even unfamiliar to the modern reader, but those words were normal words to Blake's contemporary audience. Overall, these are simple, common words, the sort of words that a child from that time period would recognize.
This fits in with Blake's purpose: He is trying to write something reminiscent of a nursery rhyme. He published this in a volume called Songs of Innocence.