In short, if your characters can hear it, it is considered a diegetic sound.
Here are a few quick highlights from the article:
Diegesis has itís roots in literature and theater. Itís the difference between telling how a story unfolds or seeing it unfold.
The term diegetic sound comes from film techniques and sound design. Mimesis is the other side of the coin.
Diegetic sounds are those sounds that the on-screen characters experience. Sounds the characters canít hear are considered non-diegetic.
Sometimes, an audio element serves as both diegetic and non-diegetic, or even transforms from one to the other.
For example, a movie character may initiate the sound but it may then transform to become part of the soundtrack. Soundtracks are a good example of a non digetic sound since the audience is the only one that will hear the music.
Traditional sound effects and Foley are another way to leverage diegetic sound.
Using sound effects as a substitute for real diegetic sound such as laughter, talking, clapping and other realistic sounds can imply a much larger, active environment as well as evoke emotion.
Diegetic sound is simply another tool to help tell your story.
Shifting from diegetic to non-diegetic or vice versa can help draw (and push) the viewer.
Diegetic and non-diegetic sound engages (even toys with) the viewer.
Alfred Hitchcock, Stanley Kubrick and Woody Allen used narration as a tool, misleading audiences to think one thing when something else was actually true.
Changing the role of music subtly involve the viewer in the action but care should be taken not to inadvertently pull the viewer out of a scene and separate them from the story.
Questions to ask:
Does the sound draw in the viewer or push them away?
Will the audio sell the scene or just sound like artificially contrived random effects tossed into the mix.
Sound is, after all, at least half of the movie.
(Edited considerably from the original text by VideoMaker Contributing Editor Hal Robertson)