As mentioned, the file system helps the OS interact with fixed storage media. It achieves this by dividing the space on a logical "slice" of physical media into "storage containers." The file system then assigns numbers to these containers and keeps track of which containers store a given file. It also determines how large the containers are and keeps track of which containers are free.
Windows XP supports three types of file systems for hard drives: FAT16, FAT32, and NTFS. (It also supports FAT12 and CDFS for floppies and CD-ROMs, respectively, but we won't cover these here because you don't have to manage these file systems.) Each logical drive needs to be formatted with one of these three file systems before use.
The file system you choose will depend on how you intend to use the drive, and your choice will have significant implications for the technologies available for the logical drive. Each file system merits a chunk's worth of explanation.