I agree with R0J0hound that it looks like a combination of things.
It looks like it almost definitely uses some type of cellular automata for a lot of things (Google it for tons of info and vids), but if they did, they did a lot of work to make it behave and look all pretty. You can see some telltale signs by the way the magic destruction spreads, and how there is a delay in filling the empty space when liquid is flowing and the container or ground breaks beneath it.
I think for the per-pixel physics they might be using a more sophisticated version of the same thing. If I were to try to do it, I would try to make a super simplified physics engine per cell, more like a vastly simplified platform behavior per pixel than like a true box2d style physics behavior. They said they're doing the simulation on CPU so I'd guess the simulation is a data-driven design, so there's just a bunch of dumb data sitting there, and the simulator runs over all of it, rather than each individual pixel being its own object. Each cell probably has a state that changes to different modes when it becomes airborne, or joins a larger body, etc.
As far as how they're making the larger objects behave like they're part of that same pixel based physics, I don't have a clue. My guess would be magic. I've always been fascinated by soft body and brittle object physics, but I never delved into much of the math of it. The thing I did with CC that newt mentioned was using a library to do most of the work.