iPhone Tethering is a technique in which an iPhone is used as a wireless modem to provide Internet access to a computer or other Wi-Fi-enabled device, like an iPad or iPod touch.
Tethering is a general technique available on many cell phones and smartphones that can access the Internet. With the right software and data plan from a cellphone carrier, it allows the user to connect their phone to a computer and use the phone's 3G Internet connection to provide wireless, always-on connectivity to the computer. The iPhone supports tethering via Wi-Fi, Bluetooth, and USB.
Tethered connections are generally slower than broadband or Wi-Fi connections, but are more portable. Tethering also often requires a monthly data plan subscription in addition to the standard phone contract.
To use iPhone tethering, you must have an iPhone 3GS or higher, running iOS 4 or higher, with a data plan that supports tethering.
Both AT&T and Verizon, the iPhone carriers in the U.S., offer data plans that include tethering starting at an additional US$20/month over the user's existing data plan. AT&T's unlimited data plan is not available for users with tethering enabled.
While tethering is the general name for this functionality, Apple's implementation of it, and how its onscreen iOS functions are labeled, is called Personal Hotspot.
For more details on setting up and using tethering, check out the iPhone Tethering FAQ