Co-location refers to the provisioning of space for a customer's telecommunications equipment on the service provider's premises. In a normal web site hosting situation, a public web site owned by "Company XYZ" would reside on a server owned by their hosting provider and located at the hosting provider's premises. The hosting provider connects the server to the Internet, owns and maintains the web site server.
In a co-location situation, a web site owner places their own web site server(s) on the premises of the ISP or hosting company in a variation of the standard hosting agreement. In this agreement, the web site owner also owns the physical server.