What could cause a toddlers lip to look whitish and shredded on the inside?  

Thrush. This very well maybe a fungal infection of the mucosal, inner, surface of his lip. This can be treated with antifungal medications prescirbed by your doctor.
Thrush! It's a fungal infection usually because of antibiotic use or inhaled/nebulized steroid use. If your toddler is still attached to his pacifier...Then there goes the culprit! have your pediatrician check it out.