Headphones image in your head; the soundstage is often described as 'wearing a stereo hat'.

Dolby Headphone attempts to give externalized sound when listening with headphones. It works with 2-channel and 5.1-channel material. With multi-channel, it actually tries to give some front vs surround directionality.

Personally, I've never found the results very sucessful. There were a couple of demos where for very brief moments I thought I was listening to speakers in front of me. But it was fleeting.

Still, it's nice to have to option.