Inosculation is a natural phenomenon in which trunks, branches or roots of two trees grow together. It is biologically very similar to grafting.
It is most common for branches of two trees of the same species to grow together, though inosculation may be noted across related species. The branches first grow separately in proximity to each other until they touch. At this point, the bark on the touching surfaces is gradually abraded away as the trees move in the wind. Once the cambium of two trees touches, they sometimes self-graft and grow together as they expand in diameter. Inosculation customarily results when tree limbs are braided or pleached.
Trees are the largest plants in Terraria, appearing mostly at the surface and often in clusters with similar height. Trees can be chopped down with an axe, with the use of explosives, or by pouring lava on the base. Destroying or chopping a tree will yield many units of wood, an essential crafting material, and give a chance of dropping one or more acorns that can be planted to grow more trees. Larger trees will yield more of these two materials when removed, since the amount of wood and acorns obtained from a tree depends on its size: one unit of wood will drop for each block of tree (including branches), and one acorn may drop for each leaf patch, excluding the top patch of leaves. It is possible to cut off parts of the tree, but cutting at the lowermost center tile will destroy the entire tree. If parts of the tree are left, they will not regrow. Tiles beneath trees cannot be destroyed while the tree stands.
To me it looks as if the old tree split in half at some point and a seed fell between,sprouted and now you have a tree within a tree. The third (smallest) red oval shows a seedling, right? same story..
The main reason is sprouting (forming adventitious root from shoot or root of fragments), it is also a type of clonal propagation. The adventitious roots are mainly developed from stem or root fragments that have been injured or stimulated by hormones or pathogenic microorganisms. If you are interested in this topic, you can see our publication in Scientific Reports 2016.
Looks to me like Ivan Bulka nailed it. The image looks like a second tree established and grew in a rot pocket created when the main tree split and now a third seedling is present. Near my house is a western redcedar that has a mountain ash growing in a rot pocket created when the tree was top-killed many years ago. The redcedar since developed two new tops from side branches and have more than doubled the height of the original tree and the mountain ash seems to be doing just fine - growing and bearing fruit every year.