Saying Y here will allow you to use a regular file as a block
device; you can then create a file system on that block device and
mount it just as you would mount other block devices such as hard
drive partitions, CD-ROM drives or floppy drives. The loop devices
are block special device files with major number 7 and typically
called /dev/loop0, /dev/loop1 etc.

This is useful if you want to check an ISO 9660 file system before
burning the CD, or if you want to use floppy images without first
writing them to floppy. Furthermore, some Linux distributions avoid
the need for a dedicated Linux partition by keeping their complete
root file system inside a DOS FAT file using this loop device
driver.

To use the loop device, you need the losetup utility, found in the
util-linux package, see
<ftp://ftp.kernel.org/pub/linux/utils/util-linux/>.

The loop device driver can also be used to "hide" a file system in
a disk partition, floppy, or regular file, either using encryption
(scrambling the data) or steganography (hiding the data in the low
bits of, say, a sound file). This is also safe if the file resides
on a remote file server.

There are several ways of encrypting disks. Some of these require
kernel patches. The vanilla kernel offers the cryptoloop option
and a Device Mapper target (which is superior, as it supports all
file systems). If you want to use the cryptoloop, say Y to both
LOOP and CRYPTOLOOP, and make sure you have a recent (version 2.12
or later) version of util-linux. Additionally, be aware that
the cryptoloop is not safe for storing journaled filesystems.

Note that this loop device has nothing to do with the loopback
device used for network connections from the machine to itself.

To compile this driver as a module, choose M here: the
module will be called loop.

Most users will answer N here.

source code:

drivers/block//loop.c