Diehl was born in Cincinnati, Ohio in 1950. His father, John A. Diehl, was a civil Engineer, and his mother, Mary, was a social worker. Raised in a devoutly Roman Catholic family, he was educated at parochial schools, and graduated from St. Xavier High School in 1968.

In 1970, Diehl moved to New York, encouraged by his sister, who had just graduated from the Neighborhood Playhouse School of the Theatre. He spent 1971 squatting in Amsterdam and returned to New York in 1972. In 1976, he moved to Los Angeles. He had always been interested in drawing and making things, and intended to pursue a career in the visual arts there. Initially he supported himself in LA by moving furniture and objet d'art.

Although he had no previous experience as an actor, Diehl's interest turned to acting after he arrived in Los Angeles. He took a three-hour scene studies class in Hollywood twice a week, and in 1979 he was cast in Action, a one act play written by Sam Shepard. In 1980, he became an acting member of Murray Mednick's Padua Hills Playwrights Festival, an annual event which brought young playwrights from throughout the United States together to live and work with such playwrights as Mednick, Shepard, Maria Irene Fornes, John O’Keefe, John Steppling, and Robert Glaudini. Diehl worked with all of the playwrights in residence over the course of his several years as an acting member of the festival.

Diehl's first significant film role was in the 1980 movie Stripes. In the 25th Anniversary DVD release of Stripes, Laroquette compared the improvisation of Candy and Diehl to the improvisation of Laurel and Hardy. In 1983, Diehl appeared in National Lampoon's Vacation, which Ramis directed.

He has appeared in more than 140 films, including Joysticks (1983), Angel (1984), City Limits (1984), Madhouse (1990), The Dark Side of the Moon (1990), Kickboxer 2 (1991), Mikey (1992), Mo' Money (1992), Gettsyburg (1993), The Client (1994), Stargate (1994), The New Age (1994), Mind Ripper (1995), A Time to Kill (1996), Pearl Harbor (2001), and Road to Nowhere (2010).

Diehl moved into a basement apartment in Greenwich Village in New York, and despite a drastic reduction in his income, he declined television roles, and chose instead to continue working in film while pursuing a serious stage career. He subsequently appeared in The Hanoi Hilton (1987), a film about the experiences of American prisoners of war in Hanoi in the 1960s/70s, and Alex Cox's Walker (1987), which was shot in Nicaragua during the Contra War. In late 1988, Diehl relocated to Los Angeles after he was cast in Sam Shepard’s A Lie of the Mind at the Mark Taper Forum.

Diehl and singer Julie Christensen were married in 1992. They live in Nashville, Tennessee, and have one son, Magnus Jackson Diehl.

He played G. Gordon Liddy in Oliver Stone's Nixon (1995), the mercenary Cooper in Jurassic Park III (2001), and in recurring roles on The Shield, Friday Night Lights, The West Wing and The John Larroquette Show. In 2000, he appeared in Failsafe, which aired live on television. Between 2002-04, he portrayed General Motors' Harley Earl in a series of 11 television commercials for Buick. The commercials were directed by Tony Scott, who had previously directed films including Top Gun and Crimson Tide.

In 1997, Diehl reprised his role in Action at the Public Theater, and in 2005 he worked once again with Padua Playwrights, appearing in two plays in Mednick's Gary Trilogy. Among others, his theater credits include Life of Mine, (with Holly Hunter) at the Mark Taper Forum, Samuel Beckett's Endgame and Happy Days, one of three plays which Diehl directed.

A member of the Actors Studio since 2004, Diehl won the Los Angeles Times Warren Award in 2012, and in 2014 won the Southampton Film Festival's Lead Actor Award for his role in the short film Kahea.

He continued to work in theater in New York, however, and frequently returned to the stage there, most notably for a Shepherd play at the Public Theater with Shepard in residence at the Signature, and Mednick’s Joe And Betty, which was produced twice on Theater Row in New York.