[It is] Not really [bad to cite an arXiv paper]*. If ths paper on arXiv provides the result you want, you are free to cite it. Before the arXiv, citing "private communication" or "pre-print" is not unheard of. On the other hand, since it hasn't been peer reviewed, you probably should double check and make sure you understand and believe the paper before you cite it (if you use one of its results crucially) (not that you shouldn't do the same for peer-reviewed papers, just that one may want to be extra careful with referring to pre-prints).
Note that there are two reasons for citations. The first is to give credit where credit is due: you do not want to look like you are appropriating someone else's result (or in some cases, inadvertantly slighting somebody by sin of omission). The second is to provide references for assertions made without proof in your paper. Obviously if you are citing for the former reason, a paper is arXiv is really no different from a paper in a published journal. If the author's right, you covered your bases. If he was wrong, then better for you, perhaps. It is with the latter case you need to be more careful. If the paper has been on arXiv for a long time and not appeared in any journals (definition of "long time" of course vary from field to field), you may want to be a bit cautious in deciding whether the foundation to your house is sound.
Also, how do you know "no publication or review seems to be in the pipeline"? I know several people (myself included) who would only include the journal ref on arXiv after it has been accepted for publication. Perhaps you should double check with the original author whether it has been submitted, and if not, why not?
* As Joel pointed out in his comments to the original question, and Emerton in his comments to this answer, there is some ambiguity as to which question I was answering.