Hallucination is a status that can only affect the player. It causes all monsters to appear as random, constantly shifting letters; You cannot tell what an item is until you step onto it, and all status information about monsters except their health is removed from the sidebar. This is accompanied by a variety of other colourful visual effects.
Hallucination seems at first to be a joke, but removes from you many vital sources of information about what you're fighting - what they are, their status effects and what mode they're in (sleeping, wandering, hunting, etc). For instance, you may corrode your equipment on an unknown acid mound, split an unknown pink jelly in the middle of a room, pop an unknown bloat and have nowhere to run from its effects, wake up a monster only to find out it is an ogre that happily clobbers you to death, et cetera. As such, hallucination should be waited out in safety whenever you are unconfident about your chances.
Although you cannot tell allies from foes while hallucinating, you will still displace rather than attack allies that you walk into, and staves and thrown items will still pick appropriate default targets. If the shifting colours make it difficult for you to identify terrain and gases, disabling visual effects with "\" can help. This does not provide any additional information but makes the screen easier to interpret and saves having to hover over terrain with the mouse.
It is caused by Potions of Hallucination (300 turns) and toads (20 turns per hit). The ability to inflict hallucination cannot be learned by allies. Hallucination can be waited out or can be cured by quaffing a Potion of Life.