It depends. Generally, you do need to prove some fluency in German nowadays. I think there's some leeway with family reunions and also with spouses.
I'm pretty sure that nearly all the people who are actually citizens and live here do speak German to some degree. It can be pretty broken in the case of first generation immigrants. Due to the intricacies of citizenship law a lot of immigrants, even second and third generation, aren't citizens.
I had a hard time today explaining some basic things to one of the patients at my work place today because his German is so bad. That happens occasionally. Basic fluency can be very basic and so basic that communication beyond very simple exchanges becomes virtually impossible. I guess that's what TerokNor meant.
*nods* Yes. I mostly know it from children, who come very late into kindergarten (with 5 for example), before school starts with 6 and thats their first and only contact with the german language. So when they are 6 they surly speak some German, but not as good as the other children, who either talk German at home or who already visited kindergarten/preschool/nursery for the last 3, 4 or 5 years. So some children already get problems in school because of this. Or they get problems, because the parents cannot help with homework, as they cannot read it in German. Though I suppose now with more and more whole day schools and such coming along that will get better.
As for becoming a citizen I think one has to do a test to prove a certain knowledge of the german law, culture and language.
But not everyone living here for quite some time has the german citizenship like Count Zero already wrote.
TerokNor