Augmented reality is an application of computer-generated imagery using live-video streams as a way to expand the real-world. The imagery is "augmented" by virtual computer-generated imagery. Augmented reality adds graphics, sounds, feedback and smell to the natural world as it exists. Both video games and cell phones are driving the development of augmented reality.
The best way to see how this works is to walk through the steps using Esquire magazine as an example- they launched their December issue with augmented reality. On the cover Robert Downey Jr. introduces you to the issue. There are several pieces of bonus content that can be accessed and controlled on Esquire's website by downloading an app and pointing the AR marker at your webcam. The augmented reality feature is all supplement content in the print magazine. So, for example, in one of the magazine's fashion features, tilting your magazine in different directions controls the weather, and the model adjusts clothing appropriately. There's also a time-based joke – check out the augmented reality component after midnight and the content is different than what you find during the day. There are interactive commercial advertisements. It's incredible.
Here is a link to see how it works first hand: