Microsoft Knowledge Base Article 322692 contains the following summary:
This article describes how to
raise the domain and forest
functional
levels that are supported by Microsoft Windows Server 2003 domain
controllers.
Functional
levels are an extension of the mixed/native mode
concept introduced in Microsoft Windows 2000 to activate new Active Directory
features after all the domain controllers in the domain or forest are
running
the Windows Server 2003 operating system.
When a computer that is
running
Windows Server 2003 is installed and promoted to a domain controller,
new
Active Directory features are activated by the Windows Server 2003 operating
system over its Windows 2000 counterparts.
Additional Active Directory features
are available when all domain controllers in a domain or forest are
running
Windows Server 2003 and the administrator activates the corresponding
functional
level in the domain or forest.
To activate the new domain features,
all domain controllers
in the domain must be
running Windows Server 2003.
After this
requirement is
met,
the administrator can
raise the domain functional
level to Windows Server
2003.
To activate new forest-wide features,
all domain controllers in
the forest must be
running Windows Server 2003,
and the current forest
functional
level must be at Windows 2000 native or Windows Server 2003 domain
level.
After this
requirement is met,
the administrator can
raise the domain
functional
level.
Note
Network clients can authenticate or access
resources in the
domain or forest without being affected by the Windows Server 2003 domain or
forest functional
levels.
These
levels only affect the way that domain
controllers interact with each other.
