Taxonomy is the branch of science concerned with classification. Or, in other words, the division of things into ordered groups.
Taxonomy emerged as a science during the 19th century from the efforts of Victorian naturalists to classify (the huge and seemingly highly diverse set of) animal species being "discoverd" at that time.
As applied to the online, digital world and its various interactive software offerings, taxonomy work is done to create divisions in a body of content and/or functionality, so that the customer or user is presented with meaningful and tractable groupings of information rather than one single, undifferentiated mass. In this sense, creating a taxonomy is the first step towards creating a navigation model for a site or application.
Of course, creating a taxonomy is one thing: designing an interface to allow a user to traverse the taxonomy quickly and easily is another thing altogether.
And this is as true for conventional taxonomies as for newer faceted schemes.
Taxonomy and sitemaps
Taxonomy is a skill and a technique used to create the (hierarchical) structure of a site, which is typically represented via dendrograms (qua tree-structure diagrams) called site maps.
The way that the structure of a site is derived is not an exact science. Sometimes it suggests itself very naturally and, from what is known of the customer, it just seems obvious. There are heuristics to help you of course: the magical number seven (the comfortable limit of short-term memory storage) is a good one for example (and never trust, like thin cooks, an information architect who proposes significantly more than seven primary navigation items).