I'll concentrate more on what can be done and what is being done to reduce money laundering, since the other responses have defined it well.
To use the example of drug lords/traffickers, they have a very unique problem: they run a cash business only. No one buys drugs with credit cards, right? So they generate literally billions of dollars in physical cash per year, and it's very difficult to make those earnings look legitimate. So to combat both the trafficking and the money laundering, we have created FBI and DEA task forces to concentrate on finding and seizing their cash and shutting down their money laundering operations.
The front businesses mentioned above are very common, but they also can only launder so much money per year. If for example I purchase a coffee company in the US, and sell them my own "coffee" from a farm I own in Guatemala for $600 a pound, I then pay myself between my two companies with a check from a legitimate business and now I can deposit it in a bank and I've laundered it. With the information age, we can monitor more of these suspicious transactions that move a lot of money in this manner. By forcing them to use smaller transactions, we can make it less attractive for them to launder cash that way.
Another great story we have tried to repeat several times was called Operation Green Ice. It took place in the 1990s in the Caribbean on the Bahamas. The FBI simply opened its own bank. They made it look legit, put an attractive woman as its CEO and put the word out on the street that they were open for money laundering. Drug lords were tripping over themselves to launder money at the FBI bank. After a month of this, the FBI just boxed up all their cash, closed their doors and flew home. They were out the money! Then they used that cash to hire more agents to fight money laundering. Pure genius.
Money laundering is defined as "any financial transaction which generates an asset or a value as the result of an illegal act." It used to apply only to organized crime groups that took money that they earned through illegal activities such as gambling, drugs, prostitution, etc. and then put that money in a legitimate account or used it for legitimate purposes. Or, the money was put into accounts in Swiss banks or in other international banks or investments. In this way, the money that was derived from a "dirty" endeavor was "washed clean" by being put somewhere else, hence the term "laundering."
Today, money laundering has a more expanded meaning. It applies to white collar crime such as tax evasion, insider trading and other things that are against the financial or tax laws. Also, today we are faced with terrorists engaging in money laundering of sorts. They collect money from legitimate sources and then use it to fund terrorism. So money could be collected ostensibly for charity, but then used for funding weapons, terrorist training, etc.
How to reduce it? We are working on that. More laws have been passed to further define what constitutes an illegal act, and more importantly, more people are being prosecuted for violating the law, which has not happened in the past. So we need good laws and strong enforcement.
Money laundering is any financial transaction which generates an asset as the result of an illegal act, then that asset (money) is invested into legal legitimate business transactions. This process makes the money "clean", it becomes "laundered". Money laundering is associated with crimes such as tax evasion, false accounting practices, drug funds, or corruption. It is an attempt to hide the source of the funds.
Money laundering is ipso facto illegal, the acts that generated the money are illegal. Historically, money laundering has been associated with organized crime. Today however, this practice is in use by unorganized offenders as well.
Money laundering refer to the process of changing the status of money considered to be obtained by illegal means such as without declaring income to save on income-tax, or by illegal operations such as smuggling.
Possession money which is generated by any illegal act cannot be disclosed to law enforcing authorities without acknowledging the commitment of the illegal act generating the money. Therefore the knowledge of possession of such money or income must be kept secret from the law enforcing agencies. In this precess it becomes difficult to use such money for expenditures of certain kind which cannot be made without making it apparent that some amount is being spent which is in excess of the legal money available for spending.
Therefore people who possess such illegal money engage in various kinds of manipulations where they are able to show the illegal money as money that has come from some legal transactions. This is the process of money laundering.