Recently I ended my employment with a company that I had been employed with for five years. Over the course of those five years there had been significant cut backs in the staffing of the local office and everyone who was still employed was expected to pick up the slack (if not a salaried employee). This was just something that everyone had to deal with or, as we were told on many occassions, we should just quit and find other employment.
About a month ago, I had surgery and was off my job for about two weeks to recover. The day I returned, I was informed that two other employees had left their positions and that the one person whom I worked with was going on vacation and I would just have to do all of the work by myself. Other co-workers who knew about my surgery had offered to help me out during this time, but they were denied due to the "no overtime" policy. I told my supervisor's supervisor that I did not think that any one person could accomplish everything that was expected by themselves. The response to me was that it sounded like I was threatening them. This was not my intention, but after a lot of thought and discussion with my fiance, I decided that I could no longer work for a company that took such advantage of their employees. The next day I quit.
Now to get to my question...I believe that I am being "blacklisted" by my supervisor when potential new employers have called to ask about my employment with this company. According to a former co-worker, she has heard this person and the team leader (another supervisor of sorts) say derogatory things about me and tell people over the phone what a terrible employee I was. I was unaware that this was legal to do. I thought that if someone called to verify my employment, that was all they could do?
I believe this is happening because I was offered a job at a competing company, and when I called them back to accept, I was told that they decided to put an ad in the paper instead. What, if any, recourse do I have for this situation?

There is nothing in the law that limits an employer to only verifying that you worked there. They are entitled to provide their honest opinion about your work. However, the operative word is honest. They may not provide FALSE information.

If they are saying, We fired her for stealing, that's false and you have legal recourse.

If they are saying, we had a situation where we needed her to take on additional responsiblities; she was uncooperative and quit without warning on us, that is true. It may not be the way you see the situation, but there's nothing inherently false about it and therefore it is protected under the law.

Your best bet is to let prospective employers know up front that you are not likely to receive a good reference from this employer, and why (and you need to do it without bad-mouthing them; not easy, I know). If everyone's job were perfect, no one would ever change jobs; a prospective employer knows this. The problem is generally not a poor reference; it's having that bad reference come out of the blue. As long as you don't let a prospective employer get blindsided by the reference, you should be okay.

I am a manager for a company that has strict rules on references. If you have witness that can prove that he is deramating your character you may have a chance to sue him.

In my limited knowledge it would be him personally liable not the company...
http://www.totaljobs.com/Contents/Editorial/WhatCanIDoAboutABadReference.html

But the operative word here, is defamatory. Just because it is negative does not mean that it meets the legal definition of defamation.