If I had to make a list of the top ten features I thought would be included in the iOS 4.1 update, HDR photography would not have been on it. HDR really came out of the blue, and one developer told me he was 'shocked' to hear that the feature was included in the next iPhone update.
Let's back up a minute. HDR (High Dynamic Range) photography is a method where pictures are taken at different exposures and combined into one image. Since the iPhone and most monitors can't really display the full light to dark range of the image, the HDR software tone maps the picture, so you see details in the shadows and don't blow out the highlights, such as a bright sky. HDR images are controversial. Some people hate them, and think it produces garish pictures. Others love the flexibility to shoot pictures in challenging lighting conditions.
I like to use HDR at times when shooting landscapes, and recently documented a photo trek where I was able to use HDR apps on the iPhone.