Obsidian is a unique crafting material created when Water and Lava collide, at which point it forms in purple Stone-like Blocks that can be mined. Obsidian appears as an Ore and is gathered similarly, but has no Bar form on its own; though it is required in order to craft the essential Hellstone Bars. Mining Obsidian requires a Nightmare Pickaxe, Molten Pickaxe, any Drill, or Bombs/Dynamite.
- Obsidian is not destroyed by Lava, despite not being of Blue Rarity.
- Dumping water directly onto Lava from a Bucket only creates Obsidian if the pool is above The Underworld; otherwise the water will evaporate rapidly.
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 Obsidian generator
Obsidian can be harvested by creating a generator. A generator is an exploit that allows the infinite creation of lava and water, to create obsidian. Liquids in Terraria can be duplicated in this way because of a game mechanism in which a full bucket will always produce one full block of liquid, while less than a block of liquid is required to fill the bucket.
This video contains a detailed explanation on how to set up the machine. (instead of just using two blocks on the lava duplicator use three or four, this will allow you to click faster like the water duplicator. since the lava will spread out faster instead of taking a bit longer to actually fall off the block)
With the introduction of mechanisms such as Pumps, wire and timers in 1.1, it is now possible to construct an automatic obsidian generator, which does not require using buckets to repeatedly refill the lava or water vats.
A sample set-up of an automatic obsidian generator can be found here: 
Video detailing the construction of a fully automated Obsidian Generator using vats and pumps.