Peter Galli at eWeek has the details:
Microsoft officials have not talked much publicly about this new feature, but Jim Allchin, the co-president of Microsoft’s platform products and services division, recently told eWEEK that this is an example of just how important the reboot issue was to the Redmond-based software giant.
“If a part of an application, or the operating system itself, needs to updated, the Installer will call the Restart Manager, which looks to see if it can clear that part of the system so that it can be updated. If it can do that, it does, and that happens without a reboot,” he said.
“If you have to reboot, then what happens is that the system, together with the applications, takes a snapshot of the state: the way things are on the screen at that very moment, and then it just updates and restarts the application, or in the case of an operating system update, it will bring the operating system back exactly where it was,” Allchin said.
If a user has Office 12 running on Windows Vista and the system has to do an update of either of them, and the user goes home leaving open files, the system would update and the screens would come back right to where they were before, Allchin said.
More by following the link, in some previous articles (1, 2, 3), and in the brief overview, but apparently 3rd party applications can be written to play too if they use the Microsoft Software Installer.