Pretty intresting info on it from the iPodTouchFans Forums:
The company (i forget what its called) that provided the locate me feature used special vans to drive around and store the GPS coordinates of wireless access points. Yes… they drove up and down every street in your city logging any access point they could find. Your iPod then picks up the SSIDs, and sends it to their servers, which in turn figure out where you are.
In order to keep the system up to date, the system will also log new SSIDs and store them based on the coordinates of the ones it already knows. Any that are in the database, but arent being picked up anymore are deleted.
Seems like alot of overhead when you could just stick a GPS receiver in it, however the biggest benefit is it works well in urban centers and indoors where GPS signals are minimal or non-existent.