I was doing literature review and I came across a paper which is in the area of my interest but has been retracted because of duplicating the figures (technical drawings) of other papers.
Can I cite this paper in my literature review?
Also, is it ethical to work on the topic of this retracted paper?
Research is about telling the truth about facts of reality. You can cite any fact of reality you want if it is relevant to your research; if someone says something, you can report that they said it. You can cite a published academic paper; you can cite a newspaper article; you can cite a letter; you can cite a Post-It note or a tweet; you can cite that thing your neighbour said to you over the back fence when he got really drunk that time.
Generally researchers cite claims/information from academic papers as a source of authoritative information that has been through the process of peer review. However, there is certainly no rule that confines academics from citing information from other sources, including sources that have not been through peer review, or have been through it, but have later been retracted. There are many cases where it might be useful to cite a paper that has been retracted. There may be cases where you want to cite something from a retracted paper, where the part you are citing is undisputed, and the cause of the retraction had nothing to do with the part you are citing. There may be cases where you want to cite a claim that has been retracted, but you still think the claim is relevant despite its retraction. There may even be cases where you want to cite a retracted paper because you want to talk specifically about it having been retracted (e.g., if you are doing research on how often and why academic papers in some field are retracted).
Now, if you cite a retracted paper, it is proper practice to disclose to your reader that it is a retracted paper, and this should be done in your bibliography where you list the citation details, and should probably also be done in your main body text (e.g., Johnson 2011 - retracted). If you are citing something from the paper that is a reason for the retraction, you should make it clear to your reader that you are citing a claim that has been retracted (and hence has not passed peer review).
The notion that retraction of a paper precludes you from citing it has several obvious absurdities. First, it would make research on retracted publications extremely awkward, if not impossible. Secondly, it would implicitly require that other sources of material that have not passed peer-review could also not be cited. Thirdly, it is tantamount to claiming that writers/editors have the prerogative to preclude you from reporting what they have written. If a politician says something scandalous, and then says "retracted!" does that mean you're not allowed to report it in your research?
Retracted papers are no longer part of the scientific record. Their original publication was in error. If there was a small fix required, a correction could be issued, but in this case it seems that the journal editors deemed it necessary to retract it. You don't know for sure the details behind their decision, but if you trust their judgement in deciding which papers ought to be published (which you implicitly do, in citing published papers), then you have no rational reason not to trust their judgement in deciding which papers ought to be retracted.
Assuming here you mean the same general area, I don't see a problem with this ethically. For example, a paper on learning in cotton-top tamarin monkeys was retracted due to mistakes (or possibly misconduct?) in data coding. It is in no way unethical for other scientists to continue to work on how cotton-top tamarin monkeys learn things.
I see at least two aspects to your question: can a retracted article, in general, be cited in other research; and can a literature review include a retracted article in its review?
Can a retracted article, in general, be cited in other research? YES. On this point, I have little to add beyond Ben's excellent answer. I disagree with those that think that only scholarly or only peer-reviewed articles should be cited in scholarly work. Anything can be cited, but especially if what is cited is not peer-reviewed, then the citing author is responsible to verify the validity of what they cite. (We should even be responsible to verify the validity of the peer-reviewed work that we cite, but because there is so much research out there, it is understandable that we generally trust the peer-review process to do this validation for us.)
Can a literature review include a retracted article in its review? YES. I want to be very clear that such an article is NOT part of the scholarly body of peer-reviewed literature--it has been retracted, so does not have that quality stamp. However, I strongly believe that a literature review should include grey literature--the body of scholarly research that is not peer-reviewed, and even when meaningful, high-quality practitioner articles or books. However, you need to be clear that if you cite grey literature (including retracted articles, in your case), you should bear the responsibility to appraise and validate the quality of such work that has not been peer-reviewed. For your readers, it would be irresponsible of you not to verify that the work you cite is valid, particularly if other scholars have not already done so (that is, through peer-review). In particular for a retracted article, you should definitely explicitly mention to your readers that it was retracted and that you are knowingly citing it anyways.
Finally, you asked, "is it ethical to work on the topic of this retracted paper"? You are free to work on the topic of any article, whether published or not, retracted or not. As long as you cite and acknowledge the source of original ideas, then you are fulfilling your ethical responsibility. If your concern is that the retracted article no longer has a standard scholarly citation, well there is a good question and answer on how to correctly cite a retracted article.
Why not cite the paper it was retracted for duplicating?
The retraction isn't a reason not to work on the same topic as that paper, but if it's retracted for plagiarism, then there are likely better papers that will fit its functional need.
