X11 forwarding serves two purposes: it is a convenience to the user because there is no need to set the DISPLAY variable, and it provides encrypted X11 connections. I cannot think of any other easy way to make X11 connections encrypted; modifying the X server, clients or libraries would require special work for each machine, vendor and application. Widely used IP-level encryption does not seem likely for several years. Thus what we have left is faking an X server on the same machine where the clients are run, and forwarding the connections to a real X server over the secure channel.
X11 forwarding works as follows. The client extracts Xauthority information for the server. It then creates random authorization data, and sends the random data to the server. The server allocates an X11 display number, and stores the (fake) Xauthority data for this display. Whenever an X11 connection is opened, the server forwards the connection over the secure channel to the client, and the client parses the first packet of the X11 protocol, substitutes real authentication data for the fake data (if the fake data matched), and forwards the connection to the real X server.
If the display does not have Xauthority data, the server will create a unix domain socket in /tmp/.X11-unix, and use the unix domain socket as the display. No authentication information is forwarded in this case. X11 connections are again forwarded over the secure channel. To the X server the connections appear to come from the client machine, and the server must have connections allowed from the local machine. Using authentication data is always recommended because not using it makes the display insecure. If XDM is used, it automatically generates the authentication data.
One should be careful not to use "xin" or "xstart" or other similar scripts that explicitly set DISPLAY to start X sessions in a remote machine, because the connection will then not go over the secure channel. The recommended way to start a shell in a remote machine is
xterm -e ssh host &
and the recommended way to execute an X11 application in a remote machine is
ssh -n host emacs &
If you need to type a password/passphrase for the remote machine,
ssh -f host emacs
may be useful.