Steve pretty much summed it up. The stabilizer system compensates for motion by "floating" some of the elements in the opposite direction of dectected movement. If there is no movement, the IS system introduces it. However, there are no hard and fast rules. :)
From the latest Canon lens brochure (that I know about, available on their website): "Optical shake is detected by gyro sensors which provide the data necessary to shift the image-stabilizing lens group in parallel to neutralize the shake. This increases the usable shutter speed range by up to 2 full steps for hand-held shooting. Except for the EF 28-135mm f/3.5-5.6 IS USM and EF 75-300mm f/4-5.6 IS USM lenses, IS lenses have two IS modes. One is for normal image stabilization and the other is for panned shots. With a monopod, the Image Stabilizer on all IS lenses operates normally as during hand-held shooting. Also, the EF 300mm f/2.8L IS USM, EF 400mm f/2.8L IS USM, EF 500mm f/4L IS USM, and EF 600mm f/4L IS USM lenses have a mechanism that prevents having the Image Stabilizer turned on while the lens is mounted on a tripod."
As you might notice from that excerpt, I think the list Frank posted is incorrect (especially since I've seen the mode switch on a 100-400). Mode 1 is for normal hand-held operation. Mode 2 is for panning, and (I would assume) disables one (the vertical or horizontal depending on orentation) set of gyros. The last line about IS being disabled if it detects being mounted on a tripod is something I'm not sure about, as it hasn't been my experience. Maybe it's just *really* sensative about detecting any movement at all, so you have to have a rock solid tripod and use a cable release and have no outside influences (ie wind) on the lens for it to disable itself.
From the manual to my 70-200: "...Mode 1 corrects all vibrations no matter whether the camera is being held horizontally, vertically, or at an angle. ...Mode 2 corrects vibrations and shaking only in the direction at right angles to the camera's panning movement. ...Set the [IS] switch to OFF when you are taking pictures with a tripod.* - Even if the [IS] switch is set to ON, the IS function does not operate because the electronic circuits in the lens automatically detect that a tripod is being used. However, electrical power is still being supplied to the [IS] unit, and battery life is roughly 20% shorter than it would be with the switch set to OFF."
*I think this is the manual error being refered to - the manual basically says even mode 2 is only for hand held, and you should always turn IS off when on a tripod, which isn't the case. Now that's what the literature says. In my experience, I have noted the following.
With the first gen (75-300) they say you can't pan with IS on. You can - you just have to take the shot before you stop moving the camera. The IS movements are much more pronounced in the first gen system, and if you pan with it you will see the view go nuts when you stop movement. However it's pretty stable up until you stop as long as you move in one direction only. As for mounting it on a tripod, forget it. It's so light and the IS so heavy-handed that it overcompensates even if there *is* any movement about 90% of the time. I have more than ten years with this lens, so I'm pretty comfortable with what I can do with it.
I've only had the 70-200 a couple of months now, so I'm still learning the nuances. From what I've seen, mode 1 works for hand-held panning shots. I haven't played much with mode 2. With the tripod mounted shooting I've done, it's apparent that a) I need a heavier tripod because it still vibrates for a bit after moving it/depressing the shutter and b) sometimes IS improves it but mostly it degrades image quality. I haven't done a lot of testing with that though, nothing in really significant wind or at slower shutter speeds.
The short answer is I would do some experimenting in the kinds of shooting situations you're usually in. Shoot a few frames with it off, then a few with it in mode 1, then some in mode 2. Do a broad enough sample that IS comes into play, and not just focusing. Make a note of which are which frames as you shoot, then compare them. Hopefully you'd see an overall pattern that suggests what you should set it to.
And I don't get the damage to focus points thing either.