Telnet is an IP application-layer protocol that gives you a text-based console session on a remote machine. You need a telnet server running on the remote machine and a client application on yours that connects to it. TCP Port 23 is the default port for telnet operation. It is quite an old protocol now with several known security issues, one of the biggest being that the username and password you supply to the distant host are passed over the network as clear text.
Is that enough or do you need more depth?
On XP machines, there is a Telnet service (services.msc from the Run prompt) that is disabled be default. If you enable it and start the service, you can telnet to the machine from another XP machine by typing "telnet computer_name" from the command prompt. You may be asked to authenticate to the machine. After that, you're remotely connected.
If you're question was prompted by the need to increase your knowledge of this old technology for school, then I'd just recommend you up to this point about it.
You're really asking quite a lot there, for example an explaination would have to go into tcp communications aswell as p2p sessions and a lot of the OSI model. Having only just passed CCNA1 (and having no relative industry experience,) i really cant help you but perhaps one of the more advanced guys here can?
on a side note what are you trying to do, intercept telnet sessions or something? lol