It is actually an illusion, and very creative. The way your brain works is it takes in signals received by the ears and prioritizes them on the basis of pitch and amplitude (volume). So what can happen is that a softer sound that is followed by a louder sound will actually be translated by the brain as the louder sound coming first, followed by the softer because the brain feels the louder, stronger signal is more important. By shifting the spacing between sound strengths and varying the difference in intensity, different sound directions can be simulated. Sound designers for high-end concerts have to take this phenomenon into effect at different venues if they are using distortion or shifting effects (left to right, top to bottom, etc...) because difference distances, harmonics and reverberations will change the paths sounds take and can disrupt intended effects. Its actually a very interesting field to study, and the new 3d technology that nvidia is marketing so well is much the same concept: Provide different inputs to each eye fast enough, and you can trick the brain into seeing something that isn't actually there.
