A payment channel is a private tab between two parties, secured by Bitcoin. It is the building block of the Lightning Network.
Opening
Alice and Bob create a funding transaction on the blockchain that locks, for example, 0.01 BTC in a 2-of-2 multisig output. Neither can move it alone. Before broadcasting it, they sign the first commitment transaction, which works as a refund so Alice can get her money back if Bob disappears.
Paying back and forth
To pay Bob 1,000 satoshis, Alice and Bob sign a new "commitment transaction" that splits the locked coins with 1,000 sats more on Bob's side. Nothing is broadcast. They can repeat this thousands of times, instantly and without on-chain fees. Each new state replaces the previous one.
Stopping cheating
What stops Alice from broadcasting an older state where she had more money? When parties move to a new state, they hand each other a revocation secret for the old one. If Alice broadcasts an outdated state, Bob has a time window to use that secret and claim all the channel funds as a penalty. Because of this, honest behaviour is the only rational choice. Users who are offline can hire "watchtowers" to watch the chain for them.
Closing
Cooperative close: both sign a final transaction paying each side its balance. It is fast and cheap.
Force close: if one side is unresponsive, the other broadcasts the latest commitment transaction and waits for a timelock to expire before getting their funds.
Why it matters
Only two on-chain transactions, opening and closing, can cover thousands of payments. Channels let Bitcoin scale without changing the base layer's rules, and with only a small loss of the base layer's security guarantees.