NOTE: In ArcGIS 9.2, the term xy tolerance has been introduced. This term is synonymous with cluster tolerance. In certain contexts the term cluster tolerance has been replaced by the term XY Tolerance.
The cluster tolerance is the distance range in which all vertices and boundaries in a shapefile or feature dataset are considered identical or coincident. To minimize error, the cluster tolerance chosen should be as small as possible, depending on the precision level of your data. For example, if your data is accurate within 10 meters, you would want to set your cluster tolerance no larger than 10 meters and smaller if possible.
A cluster tolerance value will be calculated for you, if you don't specify one and instead accept the default (0). The default cluster tolerance of zero represents the minimum possible tolerance value that is calculated in the units of the spatial reference of the input. It does not actually mean zero.