Defense reduces the chance to be hit. It acts in direct opposition to the attacker's "attack" stat. Armor is what reduces damage taken, and it acts in direct opposition to the attacker's armor penetration.
Note that defense can go higher than 100. A character with 120 or 130 defense is almost completely immune to all attacks (it makes the health potions essentially useless since all attacks, even from the most powerful creatures miss) but not to some special attacks. The mere overwhelm abilities of mabaris, dragons, spiders or the grab of ogres can kill the unarmored character instantly (verified at normal difficulty, level 22 with 136 defense, 6 armor and 325 health point was depleted in 5 seconds). Reaching 130 defense means dexterity must be raised to at least 65 (with +15 defense from various items). This build is a very viable and spectacular choice for the players who don't mind unbalancing the game but it must be made early in game.
Reaching high defense is much easier for archers due to their Defensive Fire. Its 30+ defense boost with the Master Archer makes it possible to reach 100 defense by the time your character enters Lothering. This build requires you to invest into dexterity and Combat Training before everything else. High levels of defense can also be reached for mages provided that they have significant amount of spellpower and the sustained spell Arcane Shield, activated.
That said, one must be aware that the following common enemy abilities will prove extremely dangerous for a high-defense/low-armor character: Dirty Fighting, Scattershot, Poison Spit, Overwhelm, Ram, Smash, Grab. A fuller discussion of risks pure defense builds take can be found here.