A digital signature scheme has some size on which it works (e.g. what kind of messages can be signed). This message size is usually related to the key size, and smaller than most interesting messages you would want to sign.
So we use a hash function, which maps an arbitrary-length message (there is some theoretical upper size limit with most hash functions, but this is not relevant in practice) to a fixed length hash, and then use this hash as input to the signing function.
For the use for digital signatures, we need the collision resistance property of the hash function:
- It should be very hard to find a pair of messages $x \neq x'$ such that $H(x) = H(x')$.
Without this property, an adversary could produce two different messages with the same hash, give me one (innocent looking one) to sign, and later come and show the other one (for which the same signature will fit, too).
Other interesting properties for cryptographic hash functions are preimage resistance (given a hash $h$, it should be hard to find a message $x$ with $h = H(x)$) – this is not that interesting by itself, since we usually already know the signed message – and second-preimage resistance (given a message $x$, it should be difficult to find a message $x' \neq x$ with $H(x) = H(x')$) – this is needed to prevent the attacker to create a second message which has the same hash as one I already signed.
Rob in his answer elaborated a bit about whether or not the found collisions (or second preimages) would be of a valid message format. While it might be that collisions with invalid messages are easier to find, with a brute-force collision search we can principally create messages of any valid format (as long as there are enough bits left to manipulate) with any given hash. If the hash function is secure, brute-force is the best way to find (second) preimages or collisions, and then the hash output size (as well as the time for one hash evaluation) becomes the limiting factor for security. (Assuming, of course, that the signature scheme itself is secure.)
For MD5, the collision resistance is effectively broken, i.e. it is not that hard to create two messages, which only differ in some part in the middle, and have the same hash. This was used in a famous attack to let a CA sign a bogus certificate.
As SHA-1 has a similar structure as MD5, it is expected that there will be found weaknesses, too, and SHA-2 (i.e. SHA-256 or SHA-512) are preferred today.
There was a competition running to define SHA-3, which should be even more secure than SHA-2. The Keccak hash function family won this competition, though there is still no final definition of the SHA-3 standard (expected to be finalized in the first half of 2014). SHA-3 has a quite different structure than MD5, SHA-1 and SHA-2, so it is expected that any weaknesses there will not carry over.