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Jailbreaking is the modification of the iphone firmware package to allow third party add ons. All you do it run a firmware package through the jailbreaking software, then when thats done, add it to you phone by doing a custom restore instead of a normal one through itunes. after it's done, you'll be able to do things like get paid apps for free, change your phone's backgrounds, use your phone as a wireless modem, and other stuff.
It's completely reversible if you ever want to go back to a stock phone, and it doesnt modify any hardware. The only (small) thing is that you can't update your phone through itunes as youre used to. to keep it jailbroken, you have to wait until software is hacked and then do the process each time you want a new update. this isnt often though