The baseband is what makes the phone, a phone. It is, for all intents and purposes, a modem that interacts with your carrier to provide calls and voice chat. It really is the phone aspect of the phone. On a locked iPhone, the baseband is locked into AT&T's network only (or the regional carrier of the country sold in with contracts to apple). ultrasn0w is a software unlock that basically allows the baseband to interact with all GSM networks (for the GSM version of the iPhone)
The catch is, the baseband CANNOT be downgraded. Once updated, that baseband is now forever locked into that version or higher. Currently the basebands have only been unlocked to a certain version (the baseband that came with 4.0.1 I believe) any iOS install past that will update the baseband to a version that they haven't been able to crack yet. If you use ultrasn0w (windows) or pwnagetool (mac), they create a custom .ispw that performs the jailbreak but removes the portion that upgrades the baseband. If you use your phone on an unsupported carrier and ever accidently update to the latest iOS without using the custom ispw, you now have a very fancy paperweight.
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