I'm sorry for my brief answer. I'll expand a bit (really, I'm inlining part of Pierce's book):

As you probably know, there are two major domains where lambda calculi appear: computability (which I know next to nothing about) and formal methods/type theory/PLs. The people talking about "showing functions can't be computed" are referencing the former. From the formal methods view, a calculus really consists of a syntax (the set of allowable terms; this is like the state space) plus a dynamic semantics (which is like the dynamics), and optionally a static semantics (e.g., typing rules). I.e., we have the following analogy (which holds best for small-step semantics; see below) between lambda calculus and physics:

semantics : programs :: differential equations : physical states.

A lambda calculus is a calculus for programs with first-class functions :)

(While ML is basically a compiler for a lambda calculus, you can even define calculi to prove things about Java if you wanted.)

Now, to answer your questions. Let's say our set of terms (our syntax) is

term := x -- var
| \x . t -- lambda abstraction
| t1 t2 -- application
| n -- natural number
| div n1 n2

and let's call a term a value if it's "fully evaluated" according to our not-yet-existent semantics; i.e., either a number or a lambda.

We clearly expect the function defined syntactically by

f := \x . div 1 0

to diverge when applied to any argument, so any semantics for our calculus should capture that somehow.

A denotational semantics would define a semantic function S[[ ]] taking our function into the mathematical (partial) function x |-> 1/0. We would also require that S is a homomorphism, so S[[ f x ]] = S[[ f ]](S[[ x ]]), which indeed is undefined in the usual mathematical sense.

A big-step operational semantics is similar to a small-step operational semantics and so I won't describe it except to say that it rather resembles an implementation of an eval/apply Scheme interpreter (but as a purely mathematical relation on terms, and usually using the fundamental LC idea of substitution instead of an "environment"). A big-step semantics often suppresses both nontermination and "bad" states arising from nondeterministic rules (think concurrency).

A small-step operational semantics is closest to the notion of a dynamics in physics (especially in the discrete case of difference equations). Let's define one. We have choices for what "div n 0" should be: it could be some arbitrary value of our choosing (or we could extend div with an extra argument to give as the answer in this case), we could "get stuck" (i.e., not allow any transitions out of such a state), or we could add an error state to the the syntax and evaluate div n 0 to error (this generalizes pretty easily to try/catch, assert(), ...). The semantics are (technically we are defining a relation called -> on terms):

If mathematical division gives an answer, so does our division program:

n/m = p
------------
div n m -> p

(I've evilly conflated mathematical numbers with their syntactic representation in our language.)

We also need more reduction rules:

t -> t'
---------------------
div t t2 -> div t' t2

t2 -> t2'
---------------------
div v t2 -> div v t2'

If we had added an error term, we'd also add the following rule:

----------------
div n 0 -> error

(Exercise: what happens if we wrote "div t 0", as I did in an earlier edit?)

Application proceeds by reducing the function first (we'll either end up with a lambda or a number, which we could avoid by typing our calculus):

t1 -> t1'
---------------
t1 t2 -> t1' t2

There are more rules for substitution and for reducing the argument (the usual choice gives strict semantics, but other choices are possible).

Then we prove certain things about the language using induction, usually induction on derivations (just a special case of well-founded induction). We can't prove much about an untyped calculus, though.

Now your first two questions should be clear, e.g.:

f v
-> div 1 0 -- by substitution rule
stuck! (i.e., no rule applies)

If we'd added an error rule, we'd get instead

-> error

There's a bit more work to show f t gets stuck (gives error) for all terms t - maybe an induction or something, right? But wait! That's not actually true! What if t is a nonterminating function call? What about f x (x is a variable)? Then we have a free variable in the program, and again get stuck!

For your last question, you could add recursion either by hand (look up "fix") or with the Y combinator, then show that (again let's look at values first, since an arbitrary term might error in a different way):

f v -> .... -> f v

in only a few steps. Then, we'd use our proof that "->" is deterministic (i.e., a partial function from terms to terms) to conclude that f v never reduces to a value, since otherwise one of the terms in the loop above would be a value also, but none of them are. qed

There's also the formal/mechanized logic/proving aspect (omitted for brevity). It's nice that it's easy to study lambda calculi with theorem provers since, as you can see, it's easy to forget a rule or make a small mistake in a proof.

(I'm being quite imprecise here: I haven't shown what rule induction is or why it's valid, or how the rule definitions work, or ... )