To further expand on the great explanation above, a common way of employing diminished stuff is with chord and scalar substitution. CSchlegel touched upon how certain chords contain the notes of other chords and how some chords might be substituted for another chord. As he said, the G7 chord has overlapping notes with the B diminished chord. So we can effectively swap one chord for the other. Typically this means using a diminished chord instead of a dominant 7th, rather than the other way around, because we usually want to increase the tension before we resolve.

Here's one way of playing a G7 chord:


E---7
B---6
G---7
D---5
A----
E----


Now take a look at this B diminished chord:


E---7
B---6
G---7
D---6
A----
E----


Similar, eh? Only one note difference. Try playing a turnaround that contains a G7 chord and substitute the B diminished chord.

Here's one way to do it in the key of D:


E---2---3---2---0---3---6---
B---3---3---3---2---2---5---
G---2---0---2---0---3---6---
D---0---0---0---2---2---5---
A-------2-------0-----------
E-------3-------------------


You'll have to adjust the timing to make it work. :)

Lets go back to the key of C again and think of a typical turnaround conatins a G7 popping up right before returning to the C chord. If you are playing a solo over this progression you'd probably play right out of the C major scale, right? Probably. So over the G7 chord you're playing a G mixolydian mode, right? But what if we pretend that the G7 is a B diminished? Well, you could play the B locrian mode, which is basically the C major scale from B to B. That would be pretty boring though--same notes, different emphasis--no big deal. However, a B diminished arpeggio actually contains one note different to the Bmb5 that we find in the key of C.

Here's a B diminished arpeggio: B D F Ab

It's a series of minor third intervals, if anyone cares. :)

That one note, the Ab, isn't diatonic to either C major or G major, so it will sound a little sour. However, in the context of the other notes it will fit in and the sourness will add a bit of tension.

Here's an example run over a G7 chord in the key of C:


E--------------------------------
B--------------3---6---3---------
G-----------4-------------4-----5
D---3---6--------------------6---
A--------------------------------
E--------------------------------


The last note is played on the return to the C chord in the progression.

Hope this helps! I'm in a bit of a hurry and might have gotten something wrong, so if anyone sees something they can go ahead and correct me.