Mercerized cotton is a special kind of cotton yarn that is more lustrous than conventional cotton. It is also stronger, takes dye a little more readily, makes the yarn more resistant to mildew and reduces lint. It also may not shrink or lose its shape as much as "regular" cotton.
Mercerization, the process by which mercerized yarn is made, is named for the British chemist John Mercer, who developed the process and received a patent for his work in 1851.
Mercer found that adding caustic soda (lye) or sulfuric acid to cotton made the fiber swell and straighten. No one was too impressed by that, but in 1890 Horace Lowe developed a process by which caustic soda was added to the yarn under high tension, which added the luster that mercerized cotton is famous for today.
The process of making mercerized cotton is rather complex; if you'd like to read more about it there is an excellent (though technical) article at FiberArts.org.
Mercerized yarn stays shiny through washing and gives a nice, somewhat fancier look to finished items.