The Inaccurate yet Simple Definition: A fantasy story set on "modern" Earth.
What's So Inaccurate about the Simple Definition:
Marketing Dorks at Publishing Houses. It's true that there are certain type of UF that must remain firmly in the genre ghetto--once you have Elves-are-walking-the-streets-of-LA, you're pretty much doomed--but your book may end up on the "Fiction and Literature" shelves if they get the whim to do that.
Neil Gaiman's American Gods is UF. I haven't been in a bookstore yet that shelves the book in the Science Fiction and Fantasy section. But James P. Blaylock's "The Rainy Season" is stuck back there, even though it's written in a high toned style that drives most fans of Robert Jordan and Terry Goodkind mental, but wouldn't make readers of Salman Rushdie pause for a minute. Why is that? Marketing Dorks.
Charles de Lint is a writer of Urban Fantasy--perhaps one of the founders. His stories are a masterful mix of folklore from Ireland and North America. Sometimes both mythos appear in the same book, sometimes one side of the coin more than the other. But what makes de Lint's work shine is how he never makes excuses for the strange things in his modern world. Characters react to these things as they will, as it fits with their character--but they have to cope with these things. In some places, the reader feels like "reality" is the illusion, the magic real, and right there if one took the time to look for it.
Could de Lint's work end up in Fiction and Literature? Not according to the Marketing Dorks. And some days I agree with that. Some days, I don't.
Urban Fantasy can be blatant--see the racecar driving elves written by Mercedes Lackey--or it can be very slight, as in Elizabeth Hand's Waking The Moon. The timeframe is limited to taking place in the last 30 years, though I'm not sure that limit is a true one. We'll have to wait and see if someone attempts an urban fantasy story set in the Victorian era, or something. UF can be retold fairy tales or myths, but retold mythos and legends aren't automatically UF.
UF can use fantasy creatures, like elves--that seems fairly common to the subgenre. It can also use magic--very often based on modern occult traditions, but sometimes in startling ways, like the painter who creates spirit people in de Lint's Memory and Dream. There can be magical artifacts, talismans, works of art. What matters is that the setting appears to be our modern, everyday world, and that much of the action takes place there. Sometimes fantasy stories begin in the everyday world, and then the adventure takes place in a magical world--that's not urban fantasy, that's a different trope.
[Editor's note, 3/3/2003: corrected an author's name.]