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The iPhone uses three (or possibly four) methods to locate you. These technologies depend on several providers including Skyhook Wireless (http://skyhookwireless.com, aka http://loki.com), Google Maps (http://maps.google.com/) and the U.S. Department of Defense Global Positioning System (http://tycho.usno.navy.mil/gpsinfo.html).
If you own a newer-model 3G iPhone, the onboard GPS system tracks your movement courtesy of a series of medium Earth orbit satellites provided by the U.S. Department of Defense. These satellites emit microwave signals, which your iPhone picks up and uses to triangulate your position to a high level of accuracy. Like any GPS system, this requires a clear path between you and the satellites, so it works best outdoors and away from trees.