A loopback device is one that simply sends data back the way it came. In networking, the lo interface is the loopback interface.
For example you can do a loopback mount. This is if you have a cd image, let's say image.iso. To read its files you would normally burn a CD from it. But using a loopback mount, this is not needed - you can just handle the image file as if it was an inserted cd:
mount -o loop,ro image.iso /mnt/loop