This is from the VMWare server 1 documentation, but the same applies to version 2
http://pubs.vmware.com/server1/wwhel...tml/wwhelp.htm
If you set up NAT (network address translation), your VM can access the external network (presumably including the Internet) with your host machine (your physical machine) acting as a proxy using the network routes available on your host system. However, with this option you will not be able to access the VM from other machines except your host machine.
Host-only networking is an option if the VM doesn't need to access any outside network. Typically this is not desirable except if what you need is to set up an isolated VM environment for testing.
Please consider reading the relevant chapters in the documentation for further information.