TronixStuff wrote up an excellent tutorial about using the AREF pin on your Arduino, as well as some info about resolution and how the analog-digital converter works. He writes:
What if we want to measure voltages between 0 and 2, or 0 and 4.6? How would the ADC know what is 100% of our voltage range?
And therein lies the reason for the AREF pin! AREF means Analogue REFerence. It allows us to feed the Arduino a reference voltage from an external power supply. For example, if we want to measure voltages with a maximum range of 3.3V, we would feed a nice smooth 3.3V into the AREF pin – perhaps from a voltage regulator IC. Then the each step of the ADC would represent 3.22 millivolts.
Interestingly enough, our Arduino boards already have some internal reference voltages to make use of. Boards with an ATmega328 microcontroller also have a 1.1V internal reference voltage. If you have a Mega (!), you also have available reference voltages of 1.1 and 2.56V. At the time of writing the lowest workable reference voltage would be 1.1V.