The problem here is that \colorbox reverts it's argument back to text mode. And, since you're using math-related macros (like \left, \right, \frac and \ell) in text mode, TeX complains about a missing $. So you need to explicitly state that you're in math mode using:
\newcommand{\highlight}[1]{\colorbox{yellow}{$\displaystyle #1$}}
I've added the \displaystyle to make sure your fractions and delimiters are expanded as usual. If this behaviour is unwanted, you can modify or remove it.
On that topic, amsmath provides \dfrac which is short for \displaystyle\frac. Such explicit use of display/text style fractions works well to force one's intent, and would eliminate the use of \displaystyle.

It is possible to improve the \highlight macro to detect the type of math mode being used. This is possible by using \mathchoice which provides typesetting choices for 4 different styles:
\mathchoice{<displaystyle>}{<textstyle>}{<scriptstyle>}{<scriptscriptstyle>}
In the updated version of \highlight the math mode is detected prior to using \colorbox, and switched accordingly inside it. Additionally, for generalization, I've added an optional argument to \highlight that allows you to switch the colour (default is yellow) as showcased in the MWE:

\documentclass{article}
\usepackage{amsmath}% http://ctan.org/pkg/amsmath
\usepackage{xcolor}% http://ctan.org/pkg/xcolor
\newcommand{\abs}[1]{\lvert#1\rvert}
\newcommand{\Abs}[1]{\left\lvert#1\right\rvert}
% \highlight[<colour>]{<stuff>}
\newcommand{\highlight}[2][yellow]{\mathchoice%
{\colorbox{#1}{$\displaystyle#2$}}%
{\colorbox{#1}{$\textstyle#2$}}%
{\colorbox{#1}{$\scriptstyle#2$}}%
{\colorbox{#1}{$\scriptscriptstyle#2$}}}%
\begin{document}
\begin{alignat*}{2}
& \lim_{\Delta x \to 0} \frac{\Delta y}{\Delta x} = \ell \\
\iff & \forall \epsilon > 0, \, \exists \delta > 0 \text{ s.t. if }
0 < \abs{\Delta x - 0} < \delta,
\text{ then } \Abs{\frac{\Delta y}{\Delta x} - \ell} < \epsilon \\
\iff & \forall \epsilon > 0, \, \exists \delta > 0 \text{ s.t. if }
0 < \highlight{\abs{x - x_0}} < \delta, \text{ then }
\highlight[green]{\Abs{\frac{f(x) - f(x_0)}{x-x_0} - \ell}} < \epsilon
\end{alignat*}
\end{document}
\mathchoice... and spruced it up a little with an optional argument for colour changes. – Werner Nov 02 '11 at 03:27\mathchoice, and I'm very pleased to learn about it.) – Charles Staats Nov 02 '11 at 13:27xcolorinstead ofcolor? – Charles Staats Nov 02 '11 at 13:29xcoloris three-fold: (1) It loadscolorby default and (2) it provides an easy user interface which extends that ofcolor, allowing one to use colour shades and mixes without formally defining them first. For example, you can use\color{black!15}(15% black) or\color{yellow!30!green}(30% yellow, 70% green), without figuring our what the RGB components of it is and using\color[rgb]{?,?,?}or\definecolor{<col>}{...}. (3) Finally, it has a large set of predefined colour names. – Werner Nov 02 '11 at 14:21