By far the best explanation of this (that I've seen) is Jon Skeet's book - and that chapter is free! Chapter 6, C# in Depth. There is nothing I can add here that isn't covered.
Then buy the book; you will be a better C# programmer for it.
Q: Why didn't I write a longer answer here (paraphrased from comments); simple. As Eric Lippert observes (here), the yield construct (and the magic that goes behind it) is the single most complex bit of code in the C# compiler, and to try and describe it in a brief reply here is na?ve at best. There are so many nuances to yield that IMO it is better to refer to a pre-existing (and fully qualified) resource.
Eric's blog now has 7 entries (and that is just the recent ones) discussing yield. I have a vast amount of respect for Eric, but his blog is probably more appropriate as a "further information" for people who are comfortable with the subject (yield in this case), as it typically describes a lot of the background design considerations. Best done in the context of a reasonable foundation.
(and yes, chapter 6 does download; I verified...)
