An iPod works just like any other mp3 player. An mp3 is a computer file, not unlike a picture or a text document. At its most basic level, it consists of a long stream of 1s and 0s which correspond with nearly microscopic electrical components. MP3s are created by converting analog signals (basic audio technology used by phones and stereo equipment, consisting of varying frequencies converted into sound) into a digital format. A digital format is more or less a mathematical representation of the analog waves, which in turn represent the actual sound or music you want to hear.
The challenge of creating an MP3 player such as an iPod is file compression. An MP3 can take up a lot of space, which is why iPods are so revolutionary. iPods compress more MP3s into a smaller area (the iPod nano being the latest breakthrough) than any other MP3 player on the market. It is not simply nano technology (extraordinarily tiny components approaching the microscopic) that makes this possible. Equally significant is the development of ever more sophisticated codecs (COmpression DEComression algorithmS) by teams of brilliant mathematicians in Apple's employ. These mathematicians have developed increasingly complex formulas which allow very large packets of information to be "simplified" into smaller pieces of information. The answer to the question "How does an iPod work" may be better answered by a calculus text book than any trendy tech magazine.
MP3 players such as the iPod work by converting these digital codes back into an analog signal that replicates the original sound, which was probably produced in a sound studio. A DAC chip (digital-to-analog converter) is responsible for the conversion, and depending upon the quality of the chip the sound quality may vary. In many cases the internal circuitry of the MP3 player may compromise the sound quality. iPods, however, have gained considerable notariety for their ability to truly represent the sound with the highest quality possible (given the quality of the sound file itself.) How an iPod really works is anyones guess, but one thing is for sure: it works!