-- since people are a bit confused about the update/restore process... this is a copy/paste from Apple's knowledge base (and if you want pictures, just click this link)

Source: http://docs.info.apple.com/article.html?artnum=305744

Updating and restoring iPhone and iPod touch software
Last Modified on: January 25, 2008
Article: 305744

You can use iTunes to update or restore iPhone or iPod touch software. Apple recommends updating iPhone or iPod touch to use the latest software. You can also restore the software, which puts iPhone or iPod touch back to its factory condition.

If you choose to update, the iPhone or iPod touch software is updated but your settings and media are not affected.

If you choose to restore, all data is erased from iPhone or iPod touch, including songs, videos, contacts, photos, calendar information, and any other data. All iPhone or iPod touch settings are restored to their factory condition. Whenever you update or restore your iPhone or iPod touch software, Apple highly recommends that you perform a sync prior to the update in order to back up any changes since your last sync. If you have movie rentals on the device, see this document before restoring.

To update or restore iPhone or iPod touch
Make sure you have an Internet connection and have installed iTunes 7.4 or later from www.apple.com/itunes. Apple recommends using the latest version of iTunes.

Connect iPhone or iPod touch to your computer.
In iTunes, select iPhone or iPod touch in the Source pane and click the Summary tab.

Click "Check for Update." iTunes will tell you if there's a newer version of the iPhone or iPod touch software available.
Click Update to install the latest version of the software. Or click Restore to restore iPhone or iPod touch to its original settings (this erases all data on iPhone or iPod touch). Follow the onscreen instructions to complete the restore process.
Restoring or transferring your iPhone settings

When you sync your iPhone to your computer, settings and other information on your iPhone are automatically backed up to your computer, including mail settings, text messages, notes, call history, contact favorites, sound settings, and widget settings. You can restore this information if you need to (if you get a new iPhone, for example, and want to transfer your previous settings to it).

To restore previous iPhone settings:

Connect the iPhone to the computer you normally sync with.
In iTunes, select the Summary tab and click Restore (this erases all data on iPhone). When prompted, select the option to restore your settings.
Notes:

Some information you can sync from the computer (photos, videos, songs) are not backed up and will need to be resynced. Photos you take with iPhone are included in the backup with iPhone software 1.1 and later.
Passwords are not backed up and will need to be entered again.

If you restored to a different iPhone, you will need to reactivate Visual Voicemail.

Deleting backups
If you need to delete a backup from a computer, follow these steps in iTunes 7.5 or later:

Open iTunes Preferences:
Windows: Choose Edit > Preferences.
Mac: Choose iTunes > Preferences.
Click Syncing (iPhone or iPod touch does not need to be connected).
Select the backup you want to remove and click Remove Backup.


Note: If you don't want iPhone or iPod touch to automatically sync, select the "Disable automatic syncing for all iPhones and iPods" checkbox. For more information, see Help in iTunes.

For more information, see the iPhone User Guide or iPod touch Features Guide or the Apple support website.