Baked textures are those that have the highlights/shadows/shading built into the texture. In terms of clothing, it would have the highlight or contor of the body built into the texture so it appears to be more natural or realistic looking. Here is are two great except on baked textures that I found online on a tutorial webiste from blu laszlo that show you what a normal texture and baked texture look like. I also like the fact that they call out that baking is not a substitute for good graphic skills. I have seen some creaters make AWESOME textures with photoshop that incorporate contours, highlights, shadows, shading that are not baked. http://www.atomcrafts.com/Tutorials/Baking/include/06_Bake.html
What is texture baking?
When light falls on an object, shadows are created that highlights the three dimensional form. These shadows will also highlight bumps and other impurities on the surface. Simulating the way light falls on a 3D subject (or Avatar) may make it appear more natural and realistic. It is possible to use rendering algorithms on a computer to simulate shading, shadows and bumps on the surface (or texture) of a 3D object. This process is commonly referred to as ‘baking’ the texture. In the context of this tutorial, texture baking therefore refers to the calculation of environmental information (lights, shadows, etc) and rendering that information as a texture than can be used to make more realistic-looking SL clothes.
Advantages and disadvantages
A word of caution: Baking textures does NOT imply that you ill all of a sudden make great-looking clothes. Baking is no substitute for good skills with your graphics program. Experienced graphics artists can probably do better just using Photoshop in creating shadows and wrinkles that when trying to do this with texture baking.
Hope this helps,