This is Anton here, and I'd like to warn you that my own biases are going to fall into this topic. This is also very much work-in-progress ...
To get it up front at the start, I think that by the time all the smoke cleared, the Reformation was on balance a Bad Thing.
OK, let's start with the start; the pre-Reformation Catholic Church.
The basic idea promulgated by the Papacy was that Christendom should have one Church, with a consistent doctrine, just like it should have one secular head - the Emperor. OK, OK, those Greeks over in Constantinople should have been part of a Universal and Catholic Church too, but they wouldn't agree on certain political and doctrinal points.
This meant that the church needed one language - Latin. Imagine the problems if my translation of the Bible says 'Thou shalt not suffer a poisoner to live' and yours says 'Thou shalt not suffer a witch to live'.
Now, things got complicated when you had over-powerful Emperors like Otto III who made a habit of appointing Popes, or overpowerful Popes like Innocent III (*) who made a habit of sacking Emperors, but after a long series of wars in the eleventh, tweith and thirteenth centuries where Pope tried to have Emperors sacked and vice-versa, it pretty much got sorted out that the Pope wouldn't intervene in politics if the Emperor didn't try and tell him what to do.
Innocent III (1199-1216), held that Kings rule because the Pope says so, and the Pope can depose Kings at will. This doctrine of Papal Supremacy (in the "Venerabilem" decree) essentially said that there is one power in Christendom - the Pope - that all must obey, or face temporal and spiritual concequences for this disobedience.
However, this doctrine didnt really stick past Innocent III and the compromise that the Pope wouldn't intervene in politics if the Emperor didn't try and tell him what to do reasserted itself.
This basic rule also more-or-less applied with independent kingdoms like England and France, although the issue of who should appoint people to those nice, rich Church positions kept cropping up - but no King tried to tell the Church what should or should not be doctrine.
Time rolled on, and the fourteenth century saw the seat of the Pope was moved to Avignon in France. Well, more accurately, the seat of one of the three Popes moved to Avignon, with a pro-French Pope there, an anti-French Pope in Rome, and a third Pope in Pisa, and all of them exchanging insults, excommunications and interdicts.
Not good for a Universal Church, huh.
Eventually, things got sorted out with the Council of Constance in 1414-18, which got things back to an even footing, with one Pope, who lived in Rome.
The wars between Pope and Emperor had a side effect; northern and central Italy became independent from both the Pope and the Emperor, and Milan, Genoa, Venice and Florence started carving out their own little Empires.
Unfortunately, the same idea occurred to a gentleman by the name of Guiliano della Rovere, better known as Pope Julius II, who was elected on his third attempt in 1503, but basically controlled the Papacy from 1484 or so. To quote the Catholic Encyclopedia "the chief task of his pontificate he saw in the firm establishment and the extension of the temporal power. For the accomplishment of this task no pope was ever better suited than Julius, whom nature and circumstances had hewn out for a soldier".
To be slightly fairer to Julius, if the Papacy has it's own lands, castles and army, then it is going to be more difficult for it's potential temporal enemies (eg German Emperor, King of France, Roman people etc) to force it into, for example, selecting their preferred Papal candidate at swordpoint. Not That That Ever Happened, Of Course.
Note that temporal powers need armies, and armies need money.
Temporal powers also need to cut deals with other temporal powers; it is notable that while the Papal-led League of Cambrai in 1508 was theoretically aimed at the Turks, it actually spent its time smacking the shit out of Venice.
Venice was the only power that could prevent the rise of Turkish power in the Mediterranean, Constantinople having fallen to the Turks in 1453, and Turkish power continued to rise until the failed Siege of Vienna in 1529.
A favoured method of raising money was selling indulgences - a method of having sins forgiven in exchange for a cash payment.
I'm sure we can all see what sort of abuses this could lead to.
The combination of the prestige of the Church being reduced by it's involvement in secular wars against Christians, combined with the abuses inherent in raising large amounts of cash to pay for the above (well, that and Julius' building and art program, including things like St Pauls and the Sistine Chapel ceiling) laid the foundation for the Reformation that was about to happen ...
The occasion of the Reformation was Martin Luther's protest in Wittenburg in 1519 against various abuses to do with the sale of Indulgences. See http://www.gty.org/~phil/history/95theses.htm for a copy
Wittenburg was part of the lands of the Elector of Saxony, Frederick the Wise and as well as the sale of Indulgences, the Germans had a couple of objections to the way the Church worked.
Firstly, if the Church in general and the Monastaries in particular were immune to taxation, then this made the burden of the costs of local defence worse on everyone else.
Secondly, the Church was clearly more interested in raising money to play politics in Italy than in the care and saving of souls.
Thirdly, the Monasteries tend to buy little and sell much on local markets, thus depressing the prices for everyone else.
Fourthly, many corrupt and incompetant church officials existed, and the Church was doing little about them.
Finally, there should be a German Church for the German people.
(as a side note, recent research by Michael Wilks among others shows that Lollardry was not a peasant-based rebel movement, but rather absolutely based around the English court, and with the tacit and overt support of the English State. The kid-glove "sentences" for heresy should have been a giveaway)
(*) Note that as a good general rule, Popes called Innocent or Pius are neither pious nor innocent. Also note that popes called Victor generally lose.
Short Bibliography : Mattingly, Renaissence Diplomacy (great summary of the Italian Wars, among other things)
The Catholic Encyclopedia http://www.newadvent.org/cathen/ (but keep your bias filter turned on ; this is Rome's version of what happened)
Project Wittenburg http://www.iclnet.org/pub/resources/text/wittenberg/wittenberg-home.html (the Lutheran reply to the Catholic Encyclopedia) Millor (ed) The Letters of John of Salisbury (John was the point man for the Archbishop of Cantebury during the Papal succession crisis of 1159. He gives a participants view of a struggle between pope and Imperial-backed anti-pope)
Internet Medieval Sourcebook http://www.fordham.edu/halsall/sbook.html (it's all good)
Lynn Nelson's lectures at UKansas are excellent ; http://www.ku.edu/kansas/medieval/108/lectures/index.html