It wipes your /data directory. That includes your apps, contacts, sms, etc.
Use titanium backup, or astro file manager to backup your apps. Titanium backs up more, but not sure what since I don't use it. Look in the market for it. There are several apps to backup/restore your sms. Also, your apps should appear in your market>downloads, so you just go through and download them all again. Your other stuff wil sync.
If you already have your recovery console, there are settings of what you want to wipe. It should format /system by itself, so just wipe /data and /cache, then install the zip or restore the nandroid, whichever format you use.
The zip format will keep your data, but you need to wipe it if you're moving from a 2.0.1 to 2.1. That's why it's preferred to a nandroid.