Site Template vs Site Definition

Site Definitions

• A site definition is the core definition of what a site is in SharePoint.
• A site definition is installed on file system of web front ends, located at ..\12\Template\SiteTemplates. This directory is language-neutral.
• A site definition consists of .aspx pages and .xml files with Collaborative Application Mark-up Language (CAML).
• A major benefit is that the Page and List definition is read locally from the file system, not from Content Database.

Site Template

• A site template (*.stp file) is created through the user interface or through implementation of the object model.
• The site template package is a package containing a set of differences and changes from a base site definition.
• The site template package is stored as a CAB-based file that can be downloaded or uploaded to site collections by users with the appropriate rights. 

When choosing whether to create a site template or a site definition, first consider the following issues:

Are the changes you need to make simple or complex? If, for example, you need to make only minor changes in the look of certain pages and add a few fields in particular lists, you should create a custom site template.

However, if you need to create new content types, add new Web Part definitions, and significantly restructure sites, you should create a custom site definition.

Can you deploy changes to the front-end Web server? If you do not have access to the file system of the computers running Windows SharePoint Services, you have no choice but to create a custom site template.

Site definition (Advantages):

• Data is stored directly on the Web servers, so performance is typically better.
• A higher level of list customization is possible through direct editing of a Schema.xml file.
• Certain kinds of customization to sites or lists require use of site definitions, such as introducing new file types, defining view styles, or modifying the Edit menu.

Site definition (Disadvantages):

• Customization of site definition requires more effort than creating custom templates.
• Editing a site definition after it has been deployed is difficult.
• Doing anything other than adding code can break existing sites.
• Users cannot apply a SharePoint theme through a site definition.
• Users cannot create two lists of the same type with different default content.
• Customizing site definitions requires access to the file system of the front-end Web server.

Site Templates (Advantages):

• Custom templates are easy to create.
• Almost anything that can be done in the user interface can be preserved in the template.
• Custom templates can be modified without affecting existing sites that have been created from the templates.
• Custom templates are easy to deploy.

Site Templates (Disadvantages):

• Custom templates are not created in a development environment.
• Custom templates are less efficient in large-scale environments.
• If the site definition on which the custom template is based does not exist on the front-end server or servers, the custom template does not work.

http://blogs.msdn.com/b/brianwilson/archive/2008/07/13/site-definitions-versus-site-templates-and-deciding-on-the-correct-customization-approach.aspx