It was created by Judge Doom and is feared by all toons, as it can fatally dissolve toons on contact. It is Doom's preferred method of passing punishment, whether they are deemed innocent or guilty. In short, Doom wanted to commit genocide.
According to Lieutenant Santino, it is a mixture of turpentine, acetone and benzene; the former two being paint solvents, and the latter being a natural constituent of crude oil and one of the most basic petrochemicals. While it is externally harmless to humans (as Eddie Valiant was seen running through a flood of it), any toon that comes in contact with it will melt slowly and painfully and is apparently the only surefire way to kill a toon.
As a well-deserved poetic justice, Judge Doom ends up being melted himself near the end of the film, after revealing himself to actually be a toon. He also invented a vehicle machine called "The Dipmobile", which would have dissolved all of Toontown into oblivion. Fortunately, it was destroyed by an oncoming toon bullet train.
Only three characters die from the Dip: the Toon Shoe, Smartass, and Judge Doom. Benny the Cab comes into contact with it, but survives (his tires end up blowing out, though).
In an early script, the Dip was going to be called "The Final Solution".
The three chemicals that create the Dip are all paint thinners, hence why it is fatal to toons.
The Dip would also be fatal to humans if ingested, given its ingredients.
Despite the description of the Dip as the only surefire way to kill a toon, the Toon Patrol are shown to permanently die of laughter as well; however, only Smartass was completely destroyed while the rest of the weasels simply came back as ghosts.