Layered Navigation helps customers more easily filter category listings and search results for specific products.  The layered navigation menu is typically located in the left or right margins of the page (shown below in the left margin).

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By default, layered navigation is enabled for Category and Price.  You can set additional attributes to be used for layered navigation under ‘Catalog > Manage Attributes‘.

Here is a detailed reference explaining how Layered Navigation works:

http://www.magentocommerce.com/knowledge-base/entry/how-does-layered-navigation-work/

Also, instructions for configuring layered navigation:

http://www.magentocommerce.com/knowledge-base/entry/layered-navigation