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Tolkien addresses this topic in some depth and there is lots of discussion on the subject in various old threads on this forum. However, sedulous champion of veracity that I am, I shall now elucidate the matter in characteristically cogent fashion.
Ainur (including Maiar) are, by nature, incorporeal beings. These beings may "array" themselves in the physical matter of creation, in whatever form they wish. While thus "clothed" (both terms are used by Tolkien) they may indulge in any activity that a naturally corporeal being might do, including eating and reproducing, and may abandon their body or reshape it at will. However, the spirit gradually becomes accustomed to the body, and these activities that I mentioned prove particularly incarnating. At some point on this road, the spirit begins to have trouble appearing in forms different from his habit. Additionally (and perhaps slightly contradictorily), the being begins to become unable to conceal the complexion of his spirit, as when Sauron lost the ability to appear in fair forms that hid his wickedness. Eventually, even a being that was by nature incorporeal will become incarnate virtually to the point that naturally incarnate beings are. At this degree of incarnation, death is effectively final since the remaining disembodied spirit is too weakened to create a new form or otherwise affect the physical realm.
Details and exceptions:
In the case of the Istari (wizards), they were deliberately fully incarnated by The Valar (or Manwe specifically, or Iluvatar--I can't remember) to accomplish a specific task with specific limitations. These limitations were partly proscriptions that could be transgressed, and were partly the natural entailments of incarnation. Gandalf and Saruman both suffered physical deaths, the distinction being that Iluvatar interceded specifically on Gandalf's behalf, whereas Saruman's soul was left homeless.
Sauron's incarnation was a gradual thing, and is clouded by his creation of The One Ring. The Ring was a reservoir for a large portion of Sauron's vitality, and as such it served as an anchor for his spirit. His body could be slain repeatedly, but as long as the Ring remained intact, he was able to draw on its power to re-embody himself. This recovery became slower and more difficult later on. Nevertheless, until the Ring was destroyed or successfully claimed, Sauron would be capable of returning.
The Balrog of Moria was likely fully incarnate, though this was presumably not always the case. The Balrogs probably incarnated due to indulging in the pleasures of the flesh, but it's possible (though unlikely, in my opinion) that Morgoth deliberately incarnated them (assuming he was capable of doing so) in order to exercise greater control over them. The drawback would be that they were one-time-use goons in an age when Elf-lords rivaled their spiritual potency.
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