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Introduction : Google AdSense
During the summer of 2003, Google introduced a new ad delivery mechanism for website publishers (both large and small) known as Google AdSense. Earlier Google AdWords ads were only available for publishers with more than 20 million impressions per month. AdSense can now cater to small niche website publishers by bringing in content targeted advertisements to their websites

From Google's own words :

"Google AdSense is a fast and easy way for website publishers of all sizes to display relevant, unobtrusive Google ads on their website's content pages and earn money. Because the ads are related to what your users are looking for on your site, you'll finally have a way to both monetize and enhance your content pages. It's also a way for web site publishers to provide Google search to their site users, and to earn money by displaying Google ads on the search results pages."

Currently Google adsense is the best paying & most reliable source of income for webmasters. Adsense program consists display of google ads through adsense for web pages and through adsense for web search.
How Adsense Works ?

If you go to Google and do a search for almost any keyword phrase, you'll notice some "Sponsored Links" that appear on the right side of the screen that are relevant to the keywords you just searched for.

These are paid ads from web site owners trying to bring targeted visitors to their web sites. The advertisers pay Google every time their ad gets a click by a web surfer.

Now you can display these same ads on your site just like Google and get paid for it. Every time an ad is clicked from your site, you will receive a certain percentage of what Google receives from the advertiser.
Why Would Google Give Away Their Money ?

With Google AdSense advertisers are getting more exposure of thier website all over the web. This will help them gaining targeted traffic better than before.

This is also good news for Google because the more traffic the advertisers receive, the faster their funds are used up. And of course, it is Google's hope that they'll continue to advertise with them and keep funneling more money into their advertising account. This is a very ingenious way for Google to keep raking in the revenue. And of course it's good news for you because you're getting paid to simply display a few text ads for free.