What is an ISO file? An ISO file put simply is a perfect copy of a disc (usually optical) stored in one file on the hard drive of a computer. ISO is uncompressed and contains even free space of said disc.
According to Wikipedia, "An ISO image (International Organization for Standardization) is an archive file (also known as a disc image) of an optical disc, composed of the data contents of every written sector of an optical disc, including the optical disc file system." (Wikipedia, ISO Image, June 2011)
This varies from a compressed archive such as ZIP, RAR, TAR, GZ, BZ2, etc, in that an archive file contains only the files and all unused sectors are removed to save space. With this in mind, one would think that an ISO file was simply an uncompressed archive.
HOWEVER, this is not entirely true. Even uncompressed, an archive file still removes completely-empty bytes. There's no need to zip up the files of an entire 40GB disc and end up with a 40GB file, unless there was actually 40GB of data that was filling the entire thing up! If there was only 15GB on a 40GB disc and you archived the entire disc uncompressed, you would end up with a 15GB file.
This is not true in the case of an ISO file. When you create an image of a 4GB DVD, you will end up with a complete 4GB ISO file, even if half the disc was unused.
This is useful because the main point of ISO files is to be able to create a disc image file and re-burn it to another disc, thus making a copy. In this case, file locations are important in addition to file data, and an burning an ISO image, we are sure that all of the files are laid down on the surface of the disc in exactly the same configuration as the master. Of course, this would only REALLY matter if you were dealing with a raw DVD video that would be more reliant on the burning process than an MPEG-2 file burned to the DVD as data.