Peter's Japan blog

Japan is a very vulcanic country and therefore has Onsens throughout the whole country. Onsens are hot spring baths that have naturally heated water from source deep underground which are geothermally heated. These waters also have many minerals in them that attribute to several healing aspects, which vary from area to area.
Originally Onsen where public baths but not play an important role in domestic tourism and are usually in a ryokan, a traditional Japanese hotel. Onsen are usually indicated on sign & maps by the ♨ sign.
Also, originally Onsen where mixed-sex, but since western influence came after the Meiji restoration, men and women are usually separated, although mixed still exists, mostly in the countryside. Usually there is also a family bath which can be reserved for a family, which is mixed-sex, but can also be used alone if you want some privacy.

Follow up:

In an onsen the typical Japanese bathing etiquette is held, this means that you wash yourself with soap & shampoo OUTSIDE the water, on a stool near a low mounted shower. Then after you've removed all of the soap from your body, then you enter the bath to have a long soaking session. One of the reasons is because the water is used by more people. Some people come to onsen just to soak themselves for a few hours in the hot spring bath.
Many Onsen also have services like massages and other typical spa-like services.
Many Onsen are part of ryokans, traditional Japanese hotels, where you can combine your hot spring with a relaxing stay in a traditional Japanese room and have a traditional dinner with local specialties. For an all-in Japanese experience this is a hot-spring ryokan is a must.

People are allowed to bring a small towel inside the baths, but are usually used for a bit of modesty when walking between the washing area and the bath itself. Normally towels are not allowed in the water but some allow you to keep them on. Some people put the towels on their head or next to the bath.
Normally swim suits are not allowed, although some onsen in bigger cities allow (and encourage) them, but this gives the onsen a more of a water park atmosphere.

I've been to a ryokan before, but not an onsen. It's a big dream to go to a hot spring ryokan in the mountains and soak in a wonderful hot bath with a great view at the mountains around you. Must be like heaven! Someday... ;p

For a list of ryokans with information and reviews have a look at: Japanese Guest Houses
A list of some major onsen destinations can be found here at Japan Guide
Online Onsen Guide
Wikipedia page on Onsens