James O'Neil has an excellent post on over on his blog and exactly what is involved in using Volume License keys & retail keys and how they must be activated in order to use all the features in Windows Vista. He describes the different ways you can activate and mentions the Key Management Server (KMS) which is a server that larger organisations can setup to allow activation by proxy of their client machines.
This is one of the ways we are trying to cut down on software piracy with regards to Windows Vista. The biggest form of piracy of Windows is leaked volume licensing keys and by making it harder to use Volume licensing keys on machines that they were not intended for (this is where the KMS comes in) we hope to reduce the number of pirated copies of Windows Vista out there.
Reduced Functionality Mode (RFM) occurs when users haven't activated Windows Vista within a given period, the hardware of the computer changes (such that Vista thinks that it's on a different computer) or Vista detects that your copy is non-genuine through the Windows Genuine Advantage Service.
There are a couple of types of RFM, "out-of-grace" and non-genuine, and each has a different way of behaving. In out-of-grace, you can still login for a limited time (in order to activate or obtain a new license key), but you can't use features like ReadyBoost, Aero Glass and Bitlocker. With Non-genuine, you can login for as long as you want but can only access local data or obtain a license. ReadyBoost and Aero Glass is not available nor can you download premium content from the Microsoft Download Center.
The above is only my interpretation of the following website, so for the definitive guide to RFM be sure to check out: http://support.microsoft.com/kb/925582