You sign up and use Lemmy from a certain server, known as an instance, which means a server running Lemmy. Each Lemmy server has its own content, which means what people on that server do, but also it shows stuff from “federated” servers, which means other Lemmies.
By default every Lemmy shows stuff from every other Lemmy. But each Lemmy can choose to “defederate” specific other servers, which means to not communicate with them and therefore not show posts, comments, replies, up/down votes or communities from that defederated server.
So, defederation means to blacklist a server. It only affects people who have accounts on the server that chose to defederate.