This is the de facto standard Linux file system (method to organize files on a storage device) for hard disks.
You want to say Y here, unless you intend to use Linux exclusively from inside a DOS partition using the UMSDOS file system. The advantage of the latter is that you can get away without repartitioning your hard drive (which often implies backing everything up and restoring afterwards); the disadvantage is that Linux becomes susceptible to DOS viruses and that UMSDOS is somewhat slower than ext2fs. Even if you want to run Linux in this fashion, it might be a good idea to have ext2fs around: it enables you to read more floppy disks and facilitates the transition to a *real* Linux partition later. Another (rare) case which doesn't require ext2fs is a diskless Linux box which mounts all files over the network using NFS (in this case it's sufficient to say Y to "NFS file system support" below). Saying Y here will enlarge your kernel by about 44 KB.
The Ext2fs-Undeletion mini-HOWTO, available from <http://www.tldp.org/docs.html#howto>, gives information about how to retrieve deleted files on ext2fs file systems.
To change the behaviour of ext2 file systems, you can use the tune2fs utility ("man tune2fs"). To modify attributes of files and directories on ext2 file systems, use chattr ("man chattr").
Ext2fs partitions can be read from within DOS using the ext2tool command line tool package (available from <ftp://ibiblio.org/pub/Linux/system/filesystems/ext2/>) and from within Windows NT using the ext2nt command line tool package from <ftp://ibiblio.org/pub/Linux/utils/dos/>. Explore2fs is a graphical explorer for ext2fs partitions which runs on Windows 95 and Windows NT and includes experimental write support; it is available from <http://uranus.it.swin.edu.au/~jn/linux/explore2fs.htm>.
If you want to compile this file system as a module ( = code which can be inserted in and removed from the running kernel whenever you want), say M here and read Documentation/modules.txt. The module will be called ext2.o. Be aware however that the file system of your root partition (the one containing the directory /) cannot be compiled as a module, and so this could be dangerous. Most everyone wants to say Y here.