In a regular short sale transaction, the seller would locate and borrow the security being sold before the sale.
Naked shorting means that the seller has not located or secured the security being short sold, and is in many cases illegal. Naked shorting is illegal because it accompanies an extreme likelihood that the security sold short will be FTD (Fail to Deliver) within the settlement period.
Naked shorting is selling something that you do not have, without confirming that you can get the security to deliver, or even that the security exists. Naked short selling has a long history.
It was seen in the Dutch Republic around 1600 and was banned in Britain in 1733 after the South Sea Bubble. Regular short selling can be done when the ability to deliver the security sold is facilitated by a loan of the asset to the seller.
A short seller would take this position if he believes the security will decrease in value in the near future. If it does, he can go out and buy the security at a lower price (using the proceeds from the higher-priced sale) and repay the loaned security by refilling the inventory of the party that lent the security to him (i.e., with the same number of shares), which is known as "covering" the short.
Some countries banned short selling in the wake of 2008. In America, there is some debate that market makers need to be better regulated for naked shorting as a means of price manipulation, even after the SEC amended regulations in 2007 to curtail such practices.