<< The digital audio out is simply an SPDIF connection for CD music output from the CDROM/DVDROM/CDRW. You can use this as an alternative to the analog connection. Supposedly the quality is better, but no-one can seem to hear the difference.
Since most recent soundcards only have one CD-In, but also have the Digital CD-In, you can connect two CDROM/DVD/CDRWs to the soundcard so that you can play CDs from both drives.
As above, this is only for music CDs played in the drive; this has nothing to do with CDROM/DVDROM/CDRW content, such as movies, MP3s, wavs, Dolby Digital..... >>
If you connect the SPDIF out directly to your stereo system the sound quality is significantly better than analogue, but I'm saying this having tested on a full-fledged stereo system with higher end tower speakers. But even with a high quality computer sound system, even: digital out on DVD-ROM --> digital in on sound card --> digital out on sound card --> sound system, should sound better than analogue.
By the way, connecting the CD-ROM SPDIF out directly to a standard stereo system with SPDIF in is potentially problematic because the voltage is incorrect. (I don't know much about electronics, but as far as I remember it's 0 - +5 V for CD-ROMs vs. the -0.5 - +0.5 V for receivers.) Most of the time it should work, but sometimes it won't. (It worked with one of my systems and I got this weird pulsing sound on another.) Theoretically it's also possible to fry your stereo system, but so far I've not heard of that happening. The voltage issues are generally irrelevant for computer sound systems though.
As for hearing the music off CDs, I'm sure you're already aware that for most Win 2000 and XP setups you don't need either the analogue or the digital out.