This is significantly field-dependent.
In many fields, including my own (mathematics/theoretical CS) citing preprints is very standard, for all the good reasons described in other current answers and their comments.
However, there are other fields — e.g. medicine and biology — where citing un-peer-reviewed work is rare, and generally viewed as bad practice except in exceptional circumstances. (Caveat: my knowledge here is second-hand, based on what I’ve been told by colleagues who work in those fields.) And it’s not hard to see the reasoning behind this: in maths, if you rely on an under-scrutinised study and it turns out to be flawed, no great harm is done; but in medicine, it could have very serious consequences. So the relative weighting of the principles “use all available information” and “guard the literature against contamination by bad work” is different.
So in sum, you should know and follow the norms of your specific (sub-)field — read what other comparable papers do, and follow that. (Or, if you find you disagree with your field’s current norms, you can of course choose not to follow them; but be aware of what issues this may cause with e.g. journal publication, and bear in mind also Chesterton’s fence.)