What is torrent encryption?

The "torrent encryption" hides the content of the torrent data traffic from a casual observer and makes it harder to determine that the traffic is in fact torrent data traffic. It was designed to make it harder for ISPs to snoop on torrent traffic (and either block it, throttle it or send nastygrams). It can also be useful for evading the effects of buggy firmware in network devices*.

The cryptography used is relatively weak. The DH key exchange is only 768 bit with a fixed prime which is almost certainly crackable by a well-funded attacker. The actual encryption is rc4 which is known to have weaknesses though I don't know how relevant they are to this particular application. MITM attacks are possible if the attacker knows the "info hash" of the torrent in question.

Also it only protects data connections. It DOES NOT hide the fact you are present in the swarm from someone scanning the tracker or dht. It DOES NOT stop the copyright enforcers from connecting to your client and downloading a copy of the file from you to demonstrate that you are illegally offering it for distribution.