Armor defines your characters ability to reduce damage received from physical attacks. For each attack the actual amount of reduction is determined randomly from within a certain range of values, where the upper limit corresponds to the armor value displayed in your Character Sheet, while the lower limit is 20% thereof (40% when wearing a shield). Additional armor against projectiles is granted by certain Traits and Skills.
However, there is a minimum amount of damage received from any attack, irrespective of how high your armor stats are. This value is set at 20% of the original damage and prevents your character from becoming invincible to any opponent.
Note that elemental attacks (based on fire, poison, etc.) bypass your armor completely. To protect from these attacks, corresponding Resistances are required instead.