In order to use the mod_rewrite rules, you need to have mod_rewrite enabled on your server and must have written the rules to your .htaccess file.
A simple explanation:
When your web server (usually Apache) receives a request for a page, it funnels the URL through mod_rewrite first before determining what file to serve. mod_rewrite compares the URL to a list of rules (these are in your .htaccess file) and modifies the URL based on those rules.
A rule could cause a URL that reads:
The parameters are passed to WordPress, and your post is found and displayed!
To create your .htaccess file in WordPress 1.2, you should go to your Options->Permalinks page and fill out the form there to your satisfaction. If you don't want the "index.php" in your URL, don't include it - you don't need it! Grab the code that WordPress generates and save it as a text file named ".htaccess". (Use Notepad!) Upload this file to the root (where your index.php is) of your blog.
Hopefully, this will enable your mod_rewrite settings and you'll be able to use spiffy cruft-free URLs!
If it's not working, first verify that you have the mod_rewrite rules copied and uploaded correctly. Sometimes this is difficult because files that start with a dot aren't visible by default on Linux systems.
You should also check that your host supports custom mod_rewrite rules. Sometimes they turn off this option for hosting plans in the name of "security". There are plenty of hosts that don't do this.