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In a nutshell, this is the difference:
In a hosted environment, one or more Linux partitions have access to certain hardware of a "hosting" OS/400 partition. This hardware includes Disk, Tape and CD-ROM. It is possible to run this type of Linux partition with no external I/O making it very cost efficient to create many Linux partitions within an iSeries system. The hosted logical partition must be started from the hosting OS/400 partition by varying on a network server description. This partition can be active only when the host server is both active and out of restricted state.
In a non-hosted environment, the I/O and devices must be completely provided through natively attached hardware. A non-hosted partition does not have access to Tapes, CD-ROM's or Disks in an OS/400 partition. Because it is not possible to move hardware dynamically between Linux partitions, it is not usually feasible to use switchable devices in these partitions. A non-hosted logical partition is not dependent on the hosting OS/400 partition for any I/O resources. The logical partition has its own disk units or the partition makes use of networking support to do a network start. A non-hosted logical partition can be started even if the primary partition is not fully active.
So, if you want your Linux partition to be completely independent of your OS/400 partition run it non-hosted. If you want to be able to share devices run it hosted. Both types of partitions have access to the virtual LAN and virtual console.
At V5R2 and above, you can download the RedHat ISO's to the IFS, load them into an Image Catalog and install Linux from a virtual optical device. You will need to manually change the virtual "CD's" if you choose this method. You can also load different distributions and have the ability to "dual-boot" your Linux server.
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