ISO is the measure of a sensor’s sensitivity to light. The numbers are the same as the ISO ratings given to traditional film. The difference is that a film only has one fixed ISO, while you can change the ISO of your sensor from one shot to the next. ISO values go in the following sequence (some cameras offer intermediate values too):
100 • 200 • 400 • 800 • 1600 • 3200 • 6400 • 12800
Each ISO value is twice the sensitivity of the one before, which makes exposure calculations more straightforward because this is the system used for shutter speeds and aperture settings too.
You can increase the ISO in poor light so that you don't have to use slow shutter speeds and risk camera shake. In full auto mode, digital cameras will adjust the ISO automatically with this in mind.
The disadvantages of higher ISOs on digital cameras are not unlike those of high-speed film. You get more noise (similar to film grain) and reduced definition.
The amount of noise you get is directly related to the size of the sensor and the number of megapixels. The small, high-resolution sensors in compact digital cameras produce much more noise at the same ISO than the larger sensors in digital SLRs.
It's like turning up the volume on an old audio cassette because the music is quiet. The music gets louder, but so does the background hiss, and the overall quality is pretty poor.
You can see that in this example where a small section has been blown up to show the image quality at ISO 100 (left) and ISO 1600 (right). Compact camera makers are constantly increasing the maximum ISO values on their cameras, but only at the cost of plummeting picture quality - no matter what the claims!
The two big problems are small sensors and high megapixels ratings. That's why digital SLRs are so much better at high ISOs than compacts. The sensors are far larger, yet the megapixel ratings are much the same.
Nikon's D3 and D700 are perfect examples. Both have full-frame sensors, but 'only' 12 million pixels. The results is truly astonishing high-ISO performance. The picture above was shot at ISO 6400, yet the enlargement shows that the picture quality is still excellent, with very little noise.