These days, there isn't much of a distinction between subdomains and directories to the search engines. Rather, either one can be used to help correctly categorize the content on the page.

1)
Historically, subdomains are significantly different from subdirectories. Technically, a subdomain relies on DNS (Domain Name System) to resolve and answer requests. It was originally conceived to organize domains and seperate smaller domains from larger ones.

For example, mit.edu has utilized subdomains to break apart content and arrays of servers. web.mit.edu is completely different from hr.mit.edu. There are several subdirectories under each, but for the most part, all HR stuff is kept under hr.mit.edu.

2)
Knowing about the technical differences between subdomains and directories is important.

While I have seen no discernible difference between the categorization of pages on google when using subdomains or subdirectories, it does make natural sense that a subdomain would consist of a group of information where a subdirectory may only contain a piece of information.

You might want to think about these differences when planning your SEO strategy.

3)
MY SUGGESTION

Use both.

Utilize descriptive subdirectory names to store your content and use URL rewriting (and maybe a bit of DNS configuration scripting) to return the subdirectory in the subdomain space.

CONCLUSION

Right now, it's more about linking and keywords. You need good links along with a good keyword strategy. Utilizing a combination of efforts (url rewriting) will help when (not if) SEO formulas change.
Source(s):
I'm a professional webmaster.


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