The fine folks at HowStuffWorks took one apart and show us what they found.
When you turn the Etch-a-Sketch upside down and shake, it coats the inside face of the glass with an aluminum powder.
When you turn a knob, it moves its bar, and this moves the stylus. The stylus scratches off the aluminum dust coating the glass to create a line on the screen.
Read the whole article (with pictures)