What is money laundering?How can we reduce it?

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.