A stream cipher is a type of symmetric encryption algorithm that operates on continuous streams of plain text and is appropriate for hardware-based encryption.
Stream ciphers can be designed to be exceptionally fast, much faster than any block cipher. A stream cipher generates what is called a keystream (a sequence of bits used as a key).
Stream ciphers can be viewed as approximating the action of a proven unbreakable cipher, the one-time pad (OTP), sometimes known as the Vernam cipher. A one-time pad uses a keystream of completely random digits. The keystream is combined with the plaintext digits one at a time to form the ciphertext. This system was proved to be secure by Claude Shannon in 1949. However, the keystream must be (at least) the same length as the plaintext, and generated completely at random. This makes the system very cumbersome to implement in practice, and as a result the one-time pad has not been widely used, except for the most critical applications.
A stream cipher makes use of a much smaller and more convenient key — 128 bits, for example. Based on this key, it generates a pseudorandom keystream which can be combined with the plaintext digits in a similar fashion to the one-time pad. However, this comes at a cost: because the keystream is now pseudorandom, and not truly random, the proof of security associated with the one-time pad no longer holds: it is quite possible for a stream cipher to be completely insecure if it is not implemented properly as we have seen with the Wired Equivalent Privacy (WEP) protocol.
Encryption is accomplished by combining the keystream with the plaintext, usually with the bitwise XOR operation. Source: DUPUIS, Clement, CISSP Open Study Guide on domain 5, cryptography, April 1999. More details can be obtained on Stream Ciphers in RSA Security’s FAQ on Stream Ciphers.