How do the PSN servers work? 10 Points to best answer.?

Alright so I got a PS3 and I'm on PSN like every day, but how does that all work? One of my friends told me that PSN has servers but their only for like downloading stuff and finding other players in a lobby, and once you find them, the game is hosted off whoever has the fastest connection. But that sounded stupid to me so can someone tell me how it works? Thanks. Oh and if XBL is the same way and if not, how it differs, thanks.