Federation is about different components in a system working together effectively, much like the 50 US states are work together under the “federal government”. In the context of Office 365, federation refers to the different software products working together seamlessly.
Office 365 is in essence a bundle of a variety of business productivity software products. These products include SharePoint Online, Exchange Online, Lync Online, and Office Pro Plus. Office 365 brings them all together under a single user interface, but it also brings them together in other functional ways. When properly configured, signing into one program automatically signs the end user into them all. Further, changes to an account in one program will also change throughout all. This is what is meant by federation, all the pieces working together to prevent redundancy and inefficiency.
The framework which allows all of these programs to work together in this way is a software called Active Directory Federated Services (ADFS).
Information on configuring ADFS can be found here: Identity Management and Deploying ADFS
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