Digital zoom comes in two flavors, the new improved "smart digital zoom" (Sony only?) and the original, which I call "dumb digital zoom".
The basic dumb version crops and then interpolates up to whataver pixel count the camera was set to; as JW explains, totally dumb.
The "smart" version does no interpolation, just the in-camera cropping. In other words, you have to set the camera to a pixel count less than its maximum for it to work, and it will only zoom as far as it can while still getting that many pixels from the sensor. With a digicam's LCD or electronic vewfinder, this could help you to see the framing you will get when you know that a crop is needed.
With a DSLR, the main advantage I can see to in-camera cropping is faster frame rates through not having to read and process the extra pixels. The "2x crop mode" of the Nikon D2X is the only example of this so far.