Diluted means that a pure substance has been contaminated with another. The above answer about food coloring and water is good. Another would be adding ice to whiskey to make it easier to get down if it's really strong.
To dilute is to make a liquid thinner or weaker by adding water or some other solvent to it. If you have dilute paint, it means you have a thinner or weaker pain made so by the addition of water or other solvent.