It's an option to lock the screen in either portrait or landscape mode regardless of how you're holding the device. So if for example, you lock the device in portrait mode, you can lay it bed without it switching to landscape mode.
The iPad has a dedicated hardware button for it, and the iPhone 3GS, iPhone 4, and iPod Touch 3rd Generation now have a software button for it courtesy of iOS 4. I just don't see why the 2nd Generation Touch doesn't have it.
I understand that the option for the screen lock is on the multitasking bar, and the 2G Touch doesn't have that, but that's no excuse in my opinion. When you double click the home button, the bar should come up on the bottom with the iPod Controls and the screen lock button.