WinMerge is a great open-source utility that's quite a step up if you're still using WinDiff.  WinMerge features easier to read results, inline editing, better desktop integration, regex support and is extendable via plugins.  Oh, and did I mention highlighting of per-character differences within a line?...
 
 
Free versus Paid
First, let me say that my all-time favorite file/directory compare tool is BeyondCompare.  BC is a very mature tool which has seen regular development since 1996.  It is rock-steady and scales well -- I've used it scripted in production environments to keep multiple servers in synch covering more than 60,000 active files.  That said, BC is not free.  Not at all expensive, but still not free.  We'll instead look at a somewhat similar, simpler and open-source tool named WinMerge.
 

WinMerge versus WinDiff -- What's the Diff?
WinDiff is the old standard when it comes to Windows-based file compare tools.  WinDiff is small (137KB), lightweight (no installation needed) and effective in its simple presentation.  It compares both files and directories.  It can be invoked from the command line along with the files/directories to compare (making it an easy go-to compare tool to suppliment other applications).   It can be used to automatically execute an editor (configurable with Notepad as the default) to allow editing either of the compared files.   With these core functions, WinDiff easily takes care of a most basic file compare needs.
 
So what does WinMerge bring to the table (and why would we consider switching)?  First, WinMerge (http://winmerge.org/) matches WinDiff on several key points:  it can be run as a standalone (not-installed) program, compares both files and directories, can be invoked from the comand line and can automatically execute an external editor.  
 
WinMerge, however, goes well beyond WinDiff on a number of features.  First, it boasts an internal editor so you are not required to pop up a new application in a new window to edit a file (though you may still do so if you prefer).  Content can be viewed with selectable Syntax Highlighting with 33 options (ASP, C/C++, CSS, HTML, JAVA, PERL, XML, etc).  Most notably, differences are shown per-line and per-character rather than just per-line as in WinDiff.  This feature alone makes WinMerge a worthy upgrade for many developers.  See the following screenshot which shows both programs comparing the same lines of two similar WEB.CONFIG files:
 

 
WinDiff (top) and WinMerge (bottom) comparing the same two WEB.CONFIG files.
WinMerge is shown using its Syntax Highlight feature.

 
Display: Integrated versus Side-by-Side
From the screenshot you'll notice that WinMerge displays files side-by-side in split-screen fashion.  I prefer this type of display since I have plenty of room to open up my diff window on my dual-monitor development system.  For those with very limited screenspace, WinDiff's integrated list may be preferable.
 
Highlighting:  Basic versus Enhanced
WinMerge has WinDiff beat hands-down when it comes to highlighting.  First, the Syntax Highlight feature is much easier on the eyes compared to WinDiff's monocolor text plus Syntax Highlighting makes differentiating between code and comments (i.e., critical differents versus non-critical) a breeze.  Going further, though, is WinMerge's per-character diff highlighting.  Note in the previous screenshot line #69.  WinDiff marks the entire line in a highlighted color.  WinMerge goes further by using a secondary highlight to also mark the difference on a character-by-character basis within the line.  In other words, we don't have to manually scan and compare between two similar lines to tell which characters are different.  Nice!
 
Selecting Items to Compare
Here's another area where WinMerge sails past WinDiff.  Both programs provide a dialog box for selecting two files or folders to open and compare.  Both also provide command-line support for doing the same.  WinMerge, however, goes well beyond WinDiff in its command line options by offering features such as recursive folder compare, auto-close if compared files already match, set custom editor window titles (descriptions), set filename filters, prevent either or both compared files from being added to the Most Recently Used file list, enable WinMerge to be closed with a single ESCAPE keypress and a few other options.
 
WinMerge also adds what every modern Windows app should have:  drag-and-drop onto the WinMerge window as well as right-click menu support in Windows Explorer.  I like to select my files from Windows Explorer.  To do so, I highlight two files at once, right-click and select "Compare".  If the files are in different directories, I right-click the first, select "Compare To" and then right-click a second file and select "Compare".  This brings up my comparison in a new WinMerge window.
 
If you are a drag-and-drop person, simply drag files (together or one-at-a-time) onto an open WinMerge window.  The comparisons will open within the existing WinMerge but will be given a new "tab".  That's right -- WinMerge is a tabbed application -- you can have multiple file comparisons open at once within the same program instance.
 
More more more...
WinMerge goes even further by adding support for version control tools (including auto-zipping, unzipping when used with the free 7zip utility), regular expression filtering for both filename and lines within a file, support for plugins (which can be configured to operate based on file extension) and a full 70 (count them: 70) defined shortcut keys/keystrokes.
 
There are more features and options than I've mentioned.  The best resource is the online manul here:
 
   http://winmerge.org/docs/manual/
 
 
WinDiff Trumps in One Notable Feature
Both programs are free and open-source (the WinDiff source code can be found here).  Both do a perfectly fine job of locating differences within files and folders.  Both allow direct (or near-direct) editing of compared files.  Beyond these basics WinMerge excels in almost every respect.....except filesize.
 
WinDiff is small and lightweight:  137KB and does not need to be installed.
 
WinMerge is not-so-small at 3MB.  The 3MB must be installed.  PortableApps offers a version that does not need to be installed but, after adding all the required library files, the standalone version bloats up to 9.9MB.
 
Therefore, if you require very lean apps with little or no footprint then WinDiff, despite its age, is still a top contender.  If, however, you have a few megabytes to spare then WinMerge is a great free option that surpasses the old standard in nearly every respect.