From Opus 17:
Generally speaking, payments for personal injury or property damage are not taxable, but recoveries for punitive damages or lost wages/income are taxable.
There are a number of variations (like, if you deducted medical expenses in a prior year that are now paid off by the settlement, you have a report a reimbursement of a deduction, and that is taxable. Or, if you received money for your damaged car and the money is more than the car was worth, the excess is taxable). This link provided gives more examples. http://www.irs.gov/pub/irs-pdf/p4345.pdf
Your attorney costs are deductible, but only as far as the damages are taxable (if 50% of your damages are taxable, then 50% of your fees are deductible). And they are a miscellaneous deduction subject to the 2% rule, so you may or may not actually benefit from claiming the deduction.
In a perfect world, you would receive a 1099-Misc from the payer that only lists the taxable part (wages and such).
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