So how does this work?
This is a general overview:
The ETag shown in the image is a sort of checksum. When the image changes, the checksum changes. So when the browser has the image and knows the checksum, it can send it to the webserver for verification. The webserver then checks whether the image has changed. If it hasn't, the image does not need to be retransmitted and lots of data is saved.
Attentive readers might have noticed already how you can use this to track people: the browser sends the information back to the server that it previously received (the ETag). That sounds an awful lot like cookies, doesn't it? The server can simply give each browser an unique ETag, and when they connect again it can look it up in its database.