Using Tor protects you against a common form of Internet surveillance known as "traffic analysis." Traffic analysis can be used to infer who is talking to whom over a public network. Knowing the source and destination of your Internet traffic allows others to track your behavior and interests. This can impact your checkbook if, for example, an e-commerce site uses price discrimination based on your country or institution of origin. It can even threaten your job and physical safety by revealing who and where you are.
A basic problem for the privacy minded is that the recipient of your communications can see that you sent it by looking at headers. So can authorized intermediaries like Internet service providers, and sometimes unauthorized intermediaries as well. A very simple form of traffic analysis might involve sitting somewhere between sender and recipient on the network, looking at headers.
Tor helps to reduce the risks of both simple and sophisticated traffic analysis by distributing your transactions over several places on the Internet, so no single point can link you to your destination. The idea is similar to using a twisty, hard-to-follow route in order to throw off somebody who is tailing you — and then periodically erasing your footprints. Instead of taking a direct route from source to destination, data packets on the Tor network take a random pathway through several relays that cover your tracks so no observer at any single point can tell where the data came from or where it's going.
To create a private network pathway with Tor, the user's software or client incrementally builds a circuit of encrypted connections through relays on the network. The circuit is extended one hop at a time, and each relay along the way knows only which relay gave it data and which relay it is giving data to. No individual relay ever knows the complete path that a data packet has taken. The client negotiates a separate set of encryption keys for each hop along the circuit to ensure that each hop can't trace these connections as they pass through.
For efficiency, the Tor software uses the same circuit for connections that happen within the same ten minutes or so. Later requests are given a new circuit, to keep people from linking your earlier actions to the new ones.
This is just an extract from the Tor overview page.For more clarity and understanding,please visit the Tor website via this link https://www.torproject.org.