Peter,
Backtesting refers to the idea of defining a strategy purely in terms of numbers, then writing a computer program to "trade" using historical data.
I wrote a series of articles that covers the concepts behind the backtesting and strategy development process (click here for the link:
Shaun Overton - InformedTrades, but here is the gist of the articles:
I defined a very simple strategy:
Buy when the RSI closes at or above 73
Sell Short when the RSI closes at or below 27
Exit from buy when the RSI closes at or below 65
Exit from sell when the RSI closes at or above 35
Then I wrote these rules in a computer program. The most popular for forex is MetaTrader. Other popular software options are TradeStation or MetaStock, which is totally unrelated to MetaTrader.
The computer program produced returns as though I had taken every signal during a two year period. Using this information, the trader can then extrapolate whether the strategy has any potential or merit.