What happens during upgrade?

A build-to-build in-place upgrade takes place on the same hardware as your previous installation. When you run an in-place upgrade, the process upgrades your entire installation in a preset sequence. The following steps explain what happens as the in-place upgrade process runs.
1. After performing all update steps, the installation software performs an In-place Upgrade.
2. The upgrade process runs and upgrades the configuration database and the Central Administration site.
3. The upgrade process runs and upgrades any data specific to the server (for example, search settings).
4. The upgrade process runs on each Web application and upgrades each site collection in that Web application.
Note:
When you install an update, it will upgrade the data for the current Office SharePoint Server 2007 installation to the newest version. To ensure that no customizations are lost, the farm property for "Reset pages to site template version during upgrade" will be set to FALSE. This is done automatically and requires no further action on your part.
5. After all sites have been upgraded, the upgrade process ends.
6. Repeat the upgrade action on each server in a server farm environment.
7. The administrator checks the upgrade log to confirm that upgrade is complete.

What happens during update?

Updating the Office SharePoint Server is a two-step process: update and upgrade. During the update step, the binary bits are replaced on the application and front-end Web servers.