| Pretty much as Tonio said, the algorithm uses:
1) Number of sites linking to you
2) Intensity of searched for terms in the text of your site
3) How close to the top of each page the searched for terms are
4) Page Title
5) Meta data (description & keywords) hidden in the HTML
6) How many times your google'd link was clicked on when searched for
7) Many other lesser factors
Google change their algorithm regularly to stop people abusing the above to get up the search rankings, and therefore to make the paid-for search more attractive to fools like me! We spend thousands every week on search terms, but it's a reasonable investment.
Hope this helps,
Ali | 
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