Looks to me like the answers above essentially have it all answered. As I understand it, Skyhook essentially references a database of known wireless access points, where it knows their physical location in the world based on their MAC address (the unique serial-number embedded in every piece of network equipment), and tries to work out where you are based you your position relative to the wireless access-points you device can see.

Here's the Wikipedia entry on Skyhook: http://en.wikipedia.org/wiki/Skyhook_Wireless

Of course, your iPod touch can't work out *exactly* where these Wi-Fi points are, but the more of them it can see, the better it can refine its estimate of your current position. So (usually urban) areas more-densely saturated with Wi-Fi hotspots are the best place to make use of Skyhook.

Of course, sometimes the people who own some of these Wi-Fi devices might occasionally move them. At times like that, if there aren't other Wi-Fi devices in range to show up the erroneous one, your position might be shown incorrectly. The Skyhook people do try to keep their info up to date though, both themselves and from submissions on their website.

Even though the iPhone has GPS, Skyhook works well in tandem with it. Skyhook is faster, and (relatively) well indoors, whereas GPS is slower and works better outdoors. Put the two together and you can get a rough guesstimate of your position quickly, with GPS refining the info soon after.
Source(s):
My own knowledge of Skyhook.
http://en.wikipedia.org/wiki/Skyhook_Wireless

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