Disabled Volume: Media Center is locked to playing at 100% volume; it is assumed that you will be controlling volume externally via your amplifier.
Internal Volume: Media Center adjusts playback volume using its 64-bit audio engine. If you want to adjust volume via the computer, this is the highest quality option.
System Volume: Any volume changes you make will adjust Windows' main volume control. If you are using Windows Vista or newer, this is a 32-bit floating point control. (so it is not as good as Media Center's)
Application Volume: This adjusts the Windows mixer volume for the Media Center application only. So other applications may still be at 100%, but Media Center's volume would be reduced.
For the highest quality, you should disable the volume control, and adjust with your amplifier.
I proposed some changes to make the controls easier to understand a while ago, but the developers decided that it was better to keep the controls familiar to existing users, rather than simplify them for new users.
I would argue that a better description would allow anyone to understand what each setting does, rather than only people who are already familiar with it.