Spell check, which debuted in iOS 3.2 for iPad, is now a system-wide addition to iOS 4 for iPhone and iPod touch as well. Words that the OS thinks you've misspelled will be underlined in red (familiar to any Microsoft Office or Mac OS X user). Tapping on them will give you a popup containing a recommended replacement. Tapping the popup replaces the misspelled word with the (hopefully!) correctly spelled one. Combined with the iPhone's existing, fairly stupendous, predictive auto-correct, it's a powerful combination.
What makes it even more powerful is the addition of "replace" to the cut, copy, and paste popup. This is also something that debuted on the iPad but moved over to iPhone and iPod touch with iOS 4.
As an added bonus, if iOS 4 autocorrects a word and you immediately backspace, a popup will appear offering to replace the correction with the originally typed word.
Text replace functions similarly to spell-check in that you can use it to swap out a bad word for a good one, but there's a different use-case behind it. Words don't have to be spelled wrong for it to work, they just have to have alternative. For example, "downloads" is spelled correctly but you might not have meant to pluralize it. Tap it to get the copy/paste popup, hit replace, and "download" comes up as an option.
For more features check out our massive iOS 4 walkthrough.