*edit: My post below gets some things wrong. See https://lemmy.world/post/149743 by @AgentGoldfish for a better explanation. You can stop reading here unless you like partially incorrect information.

There have been several answers to this, but I don't think everything has been fully explained.

Instances are not aware of other instances by default. So, if someone creates a new #Lemmy or #Kbin server nobody will be aware of it.

Now, when a user on your new Lemmy server (CoolLemmy) starts following a community or user on another server (LemmySphere), that server becomes aware. CoolLemmy will start showing all the content from LemmySphere in its "All" feed. Also, all content from CoolLemmy starts to appear in the "All" feed on LemmySphere.

Next, when a user on CoolLemmy starts following a community on SpaceLemmy, LemmySphere will also show SpaceLemmy content in their All feed. This is how one big web of content starts growing (federating) across all of these different instances.

Sidebar (and this is an important point): let's say a CoolLemmy user posts a comment on a LemmySphere thread. What happens? Their comment, and any images, etc., are saved on CoolLemmy, not LemmySphere. Please keep this in mind if you are on a server that doesn't want NSFW content, illegal content, drug content, etc, on their server. If you think you are posting NSFW content on a NSFW Lenny instance you are actually posting it on your local server, which may get you banned.

So, let's say SpaceLemmy starts doing things that LemmySphere doesn't like. LemmySpere defederates (blocks) them. Users on SpaceLemmy will still see LemmySphere posts and comments (public content can be viewed by anyone). SpaceLemmy users can add threads and comments (which, remember, are saved on SpaceLemmy) on Communities and threads on LemmySphere, but LemmySphere is not going to show them to their users - SpaceLemmy has been blocked. SpaceLemmy users will still see them and, because CoolLemmy and SpaceLemmy are still federated, CoolLemmy is still going to see those comments and posts.

If CoolLemmy also defederates SpaceLemmy then, in this example, only SpaceLemmy users will see SpaceLemmy content.

If SpaceLemmy defederates both SphereLemmy and CoolLemmy, only then will SpaceLemmy stop showing content from those other servers.

Defederating is the equivalent of closing your eyes and putting your fingers in your ears and saying, "la la la I can't hear you" and actually meaning it.