How timing belt works?

To understand the working of timing belt, lets first understand a belt drive.
A belt is a looped strip of flexible material, used to mechanically link two or more
rotating shafts. They may be used as a source of motion, to efficiently transmit
power, or to track relative movement. Belts are looped over pulleys. In a two-pulley
system, the belt can either drive the pulleys in the same direction, or the belt may
be crossed, so that the direction of the shafts is opposite.

Fig. 1 Open belt drive: Both shafts rotate in the same direction

Fig. 2 Crossed belt drive: Both shafts rotate in opposite directions

Fig. 3 Open belt drive

Fig. 4 A pair of V-Belt Credit: wikipedia

 Timing belt
A timing belt, or cam belt (informal usage) is a part of an internal combustion
engine that controls the timing of the engine's valves.
% In the internal combustion engine application, the timing belt connects the
crankshaft to the camshaft(s), which in turn controls the opening and closing of the
engine's valves. A four-stroke engine requires that the valves open and close once
every other revolution of the crankshaft. The timing belt does this. It has teeth to
turn the camshaft(s) synchronized with the crankshaft, and is specifically designed
for a particular engine. The job of the timing belt is to turn the camshaft(s) at exactly
1/2 the speed of the crankshaft while maintaining a precise alignment.  This means
that the crankshaft will make two revolutions for every revolution of the camshaft. 
Engines will have at least one camshaft, or as many as four camshafts in some of
the V-type engines.  The camshaft causes the intake and exhaust valves to open
and close in time with the pistons, which move up and down in the cylinders.  The
valves must open and close at exactly the right time in relationship to the piston
movement in order for the engine to run properly. If the valve timing is not correct,
the pistons will come up and hit the valve, causing major damage to the engine by
bending a valve, destroying a piston or bending a piston rod.

%
 Why use belt drive and not chain drive?
Gear and chain systems can also be used to connect crankshaft to the camshaft at
the correct timing but they constrain the relative location of the crankshaft and
camshafts. As the distance between centers of shafts increases, the driver and
follower for such methods of transmission become large, unwieldy, and costly, and
rigid links may be used to connect the rotating pieces, as in the case of parallel
rods of a locomotive. For a further increase of distance, the transmission is attained
by means of belts and pulleys, and, if the distance is very great, by wire ropes and
sheaves. Even where the crankshaft and camshaft(s) are very close together, as in
pushrod engines, most engine designers use a short chain drive rather than a direct
gear drive. This is because gear drives suffer from frequent torque reversal as the
cam profiles "kick back" against the drive from the crank, leading to excessive noise
and wear.

Working
% The timing belt rides on a crankshaft pulley and either one or two camshaft
pulleys, depending on whether the car is a single overhead cam, double overhead
cam, or, in the case of rear wheel drive vehicles, a mid-engine cam. Each of the
pulleys has a timing mark on them. The marks must all line up according to the
timing specifications on the car. The pulleys are toothed, as is the belt. This keeps
the belt from sliding around on the pulleys.
%
% As the crank turns, it turns the crankshaft pulley, sending the timing belt in
motion. The timing belt, which runs up to the camshaft pulleys, turns the camshafts
of the engine. In turn, the lobes on the camshaft push the valves into an open or
closed position. In a four-stroke engine, there are four phases:
% 1. Intake: Air and fuel get sucked by a vacuum through the intake manifold
and into the cylinders on the first down stroke of the piston. At this time, the intake
valves are open and the exhaust valves are closed.
% 2. Compression: The air and fuel mixture is compressed on the first
upstroke of the piston. At this time, all valves are closed.
% 3. Combustion: The compressed air and fuel mixture is ignited by a spark
from the spark plug on the second down stroke of the piston. At this time, all valves
are closed.
% 4. Exhaust: What comes in must go out---any excess air and fuel left in the
cylinder gets pushed out through the exhaust valves on the last upstroke of the
piston. At this time, the intake valves are closed and the exhaust valves are open.
If a timing belt stretches or breaks, it does not keep the valves in time with the rest
of the engine. The valves must open and close at the proper time, hence "valve
timing." If the valves are not open or closed at the appropriate time, the car will
either run badly or not at all. There is one major thing to keep in mind when dealing
with timing: most engines with double overhead cams and a good percentage of
engines with single overhead cams are interference motors. If the timing is off in an
interference engine, the valves will open or close at the wrong time, causing them
to hit the piston on the upstroke.

Automobile engines can be classified as either Free-Running or Interference,

depending on what occurs if piston/valve synchronization is lost. In the free-
running engine with the crankshaft still moving, there is enough clearance
between the valve and piston, even if the cam stops with a valve fully open.
However, interference engines usually sustain damage if synchronization is
lost. As illustrated, disrupted synchronization allows the piston and valve to
collide causing damage and very expensive repairs for the vehicle owner.
Damage can occur to valves, pistons, or heads, and in some cases,
completely ruin the engine. Most import (with higher compression engines)
and most car and light truck diesel engines are interference.
Links:
Importance of timing belt replacement
http://www.youtube.com/watch?v=DGh-3fvK61I