"In America (at least) there is a company called Nerf. They sell foam rubber versions of sports equipment and weapons for kids to play with. Plastic bows with Foam Rubber Arrows, Plastic dart guns with foam rubber darts that have suction cups on the end. Foam Rubber Footballs. Foam Rubber Swords.
http://www.nerfcenter.com
So, If you were to take a MMOG weapon that was deadly, and reduce it in power till it was more of a toy than a weapon, you "nerfed" it.
Eventually, the term came to cover all reductions in power instead of just weapons."