Placing Vector Artwork
The same theory applies to vector graphics from Illustrator. Previously, when you placed an Illustrator file into a Photoshop document, the vector graphic was rasterized, or turned into pixels. Once it was rasterized, you couldn't make it larger or edit the original—you'd have to start over again. In Photoshop CS2, the vector object becomes a Smart Object that still refers to the original Illustrator artwork. Here, the placed artwork has been scaled, rotated, made 50% see-through, and had a drop shadow added.
I double-clicked the Smart Object to edit the artwork in Illustrator, in which I changed some colors and added to the graphic. As soon as I saved the artwork in Illustrator and returned to Photoshop, the Smart Object updated to reflect these changes, while preserving the size, position, opacity and layer effects.
I could even scale the graphic to a much larger size without any loss of quality, again because the original vector artwork is referenced at all times.
Unfortunately you cannot do anything to the Smart Object itself that involves changing the content of the layer. For example, you cannot apply filters or paint on the layer. Depending on the content of the Smart Object, you can transform it in a number of ways, apply a layer mask, and so on.