In the old days of web design, we had to put all of our files in folders, so having a path like example.com/category/sweaters/cashmere/winter-special.html was really common. You could also remove any part of the path and be sure you would get an index page, such as example.com/category/sweaters/index.html.
In a front-controller CMS like Drupal, all the paths are arbitrary, so a hierarchical folder structure has to be faked with URL Aliases. Luckily the community maintains two modules to round out this functionality in Token and Pathauto, along with the excellent Entity API module and the Entity Tokens that comes bundled with it. However, Tokens were completely (and necessarily) rewritten from Drupal 6 to Drupal 7, and some of the cool things you could do with pathauto to emulate old-school folder structures became less transparent.
After a few minutes of searching the issue queue, lo and behold, a replacement for Drupal 6's "catpath" token:
category/[term:parent:url:path]/[term:name]
If your taxonomy is properly arranged in a hierarchy, this acts as a recursive loop to generate the terms that should be properly nested. That means that example.com/sweaters/cashmere/ should show you all the nodes tagged with cashmere, and likewise for example.com/sweaters.
OK, but what about the nodes? No problem there either:
category/[node:category:url:path]/[node:title]
Again, this creates a recursive loop where the path of the node depends on the path of the term, and that depends on its parent terms. (if you'd like to add .html to the end, that is fine too).
The pattern is different depending on the name of your vocabulary. In a site upgraded from Drupal 6, the word "category" will be replaced by a vocabulary ID.
category/[node:taxonomy-vocabulary-2:url:path]/[node:title]
if your field has multiple values you may need to address the term with a delta:
category/[node:taxonomy-vocabulary-2:0:url:path]/[node:title]
Last but not least, if you want absolute control over which term is used you may also want to check out Dave Ried's Taxonomy Entity Index module.
BTW I never used to like putting "category" in front of my URL aliases, but there is a good round up of some security holes you may open by not putting some static text in front of pathauto patterns: Pathauto Patterns that can be Dangerous