AFAIK, it works the same online as your typical magnetic strip card, however, it's associated with a PIN which likely (hopefully) isn't stored by the merchant. Similar to a card security code (CVV).

Otherwise, offline you place it into a card reader and enter a PIN. The card then authenticates the transaction only if the PIN matches. The card stays within the reader as you enter the PIN.

Further reading,

http://en.wikipedia.org/wiki/Chip_and_PIN

http://en.wikipedia.org/wiki/EMV