it only works if you have sound check enabled in iTunes - it finds the "normal" level for all the songs in your library and adjusts the volume meta tag (in decibels I think) for each song (so in theory when you play your music, all the songs are at the same volume)
Then when you turn it on on your iPod, it reads the volume tag iTunes set. So when you play music on your iPod, the songs are all the same volume - great if you listen to a lot of rock and classical. That way you don't have to get your iPod out to turn the volume down when a rock track comes on (or up when a classical piece plays).
The only problem I have with it, is that the games like to turn Sound Check off - so if I want to play a game, all of a sudden I have music blaring though my headphones 🙁