I also am using arena (just got it) and have seen this error a few times.
It is a bug of some sort in the software. I do not yet know how to fix it other than exit the game and start a new game. Its not the houdini engine, its something in arena that thinks moves are illegal all of a sudden, even legal moves. Once it is broken, it stays broken. I think the internal move list is corrupted and the board does not match what is in memory, so when you move what you SEE it really is an illegal move. But that is just my best guess.
Anyway, restart the program and try again.
On Arena 2.1 I go to try to vs. houdini 1.5 and here is the pgn
[White "Egg_nogin"]
[Black "Houdini 1.5"]
[Result "1-0"]
1.e4 e5 2.Nf3 ,... 1-0 Arena Adjudication. Illegal move!
this isn't just for Nf3 too other positions it says illegal move...
Is Houdini resigning because he is intimidated by my 1100 blitz rating and is making an excuse, or is this just a bug?
If you know how to make houdini more self confident or fix the bug I would like to know how. thanks