It refers to the absolute path and filename of the script that calls it. So, if I created a test script on my local machine, and say
I would get this
If, say for example I had 2 scripts, called test1.php and test2.php, and I included test2.php in test1.php like this
echo __FILE__.'<br />';
I would get this output
So it will always show the full path and filename of that script.