The state in which the viewer of a film ceases to view the film as a sequence of images and, rather, begins to experience the film from the perceptual viewpoint of the camera. The viewer ceases to distinguish between "cinema" (the medium in question) and "reality": the cinematic image becomes, to the viewer, his or her only reality. This is often cited as an attribute of mainstream Hollywood cinema (especially in relation to the continuity style); however, nearly all films try to encourage this state of awareness1. Loss of medium awareness is experienced by the viewer as a sense of being "lost" or "immersed" in the world of the film, to the exclusion of all else.2
The environment in which a film is seen may affect the viewer's loss of medium awareness. Some have even argued that a loss of medium awareness requires darkness and a large image and therefore can only occur in the environment of the theatre. While I'm not sure about this theory (I've definitely experienced a loss of medium awareness while watching Crouching Tiger, Hidden Dragon on DVD), the proper environment can certainly aid in immersing the viewer in a film.3
At times, the viewer's loss of medium awareness is broken by accidental elements of the film (a boom mike intrudes into the top of the frame, the cameraman's reflection is seen in a mirror, and the like). At other times, however, a filmmaker may attempt to jar the viewer by creating medium awareness, often by breaking the fourth wall. This is usually effected by causing one of the characters to address the camera/viewer: there's a scene in Ferris Bueller's Day Off which is a perfect example of this sort of creation of medium awareness. Other techniques which can be used to force the viewer to acknowledge the artificiality of the cinematic experience can include the use of jump cuts or, as in the case of Bruce Connor's A Movie, the use of elements of the cinematic apparatus as an element of the film itself.
1Memento and Pi spring to mind as examples of 'avant-garde' films which create a high level of loss of medium awareness.
2Interestingly, many people seem to consider a "good" film to be one which is able to bring about a loss of medium awareness.
3I've never been able to lose myself in an in-flight movie.
See Richard Allen's "Projecting Illusion" for an in-depth examination of loss of medium awareness and the psychological aspects of this experience.