Finding the error in this proof that 1=2

Hint $ $ When debugging proofs on abstract objects, the error may become simpler to spot after specializing to more concrete objects. In your proof the symbols $\rm\:x,y\:$ denote abstract numbers, so let's specialize them to concrete numbers, e.g. $\rm\:x = y = 3.\:$ This yields the following "proof"

$$\begin{eqnarray} 3^2 &=& 3\cdot3 \\ 3^2 - 3^2 &=& 3\cdot 3 - 3^2 \\ (\color{c00}{3 + 3})\:(\color{c00}{3 - 3}) &=& \color{c00}3\: (\color{c00}{3-3}) \\ \color{#c00}{3 + 3} &=&\color{#c00} 3\ \ {\rm via\ cancel}\ \ \color{c00}{3-3} \\ 2\cdot 3 &=& 3 \\ 2 &\:=\:& 1 \end{eqnarray}$$

Now we can find the first false inference by finding the first $\rm\color{#c00}{false\ equation}$ above; if it is equation number $\rm\: n\!+\!1,\:$ then the inference from equation $\rm\:n\:$ to $\rm\:n\!+\!1\:$ is incorrect (above: "via cancel $0$")

Analogous methods prove helpful generally: when studying abstract objects and something is not clear, look at concrete specializations to gain further insight on the general case.

That certainly is an error, although there is an error that precedes it.

HINT: Look at all the places you have $(x-y)$ in your proof. What is $x-y$? What are you doing with $x-y$ each time it shows up?

In third line you have written:

$(x+y)(x-y) = y(x-y)$

Since $x=y$, we can't cancel $(x-y)$, as that equals 0.

Cancellation law in any Integral domain is the following:

Left cancellation law: If $a\neq 0$ then $ab= ac$ implies $b=c$.
Right cancellation law: If $a\neq 0$ then $ba=bc$ implies $b=c$.