A mythical substance which is supposededly vital to the functioning of electronic equipment. Therefore when the magic smoke leaks out, the equipment stops working.
This term is often heard when some hapless individual wires equipment up backwards or to the wrong voltage supply, causing the circuit boards to fry. At this point, some wag will say "that won't work again, because you've let the magic smoke out".
You idiot, you've let the magic smoke out!