If your system goes belly up, you simply replace everything on your hard disk with what is in the backup and you essentially get back to where you were at the moment you took the backup. Naturally, everything you have added to your hard disk after you took the backup will be lost.
Not a good idea to take a backup after time limited programs have been installed (like anti virus packages with annual subscriptions) as you'll have a bunch of expired programs when you restore from the backup.
A short explanation of partitions. Say you have a large room and shit hits the fan. You have to hose down the entire room. But if you had two rooms, and the mess happened in one of the rooms, then you only need to clean that room - everything in the other room is intact. [edit] Eww! Gross.
When a system gets infected or otherwise messed up, in 99.99% of the cases it is the C drive that gets it (the one that holds Windows). If C drive is all you have, everything is gone, but if you have partitions on your hard drive, e.g. C, D, ... etc. (not counting the CD/DVD drive which has a letter too, usually the last), then you only need to format the C partition and reinstall everything that was on it; all the data in the other partition(s) stays as it was.
Now this makes backups a lot easier. Unless you are very unlucky and the entire hard disk need to be replaced, you can get away with backing up just the C partition. After a clean install, the data on your hard disk will usually fit on a single DVD (not on Vista though, as that is a pig). So take a backup and label it with the date and everything, and keep it somewhere safe. This is your master - clean system backup.