"Prequel" is a handy word. So useful - yet so abused and mistreated. It's going to need a lot of therapy to overcome the trauma.
The word is simple to understand: Take the start of the word "previous" and the end of the word "sequel" and stitch them together to get the portmanteau "prequel": A sequel that chronologically places its events before those of the original work. A good example of a prequel is the film Indiana Jones and the Temple of Doom, which takes place in 1935, a year before the setting of the previous movie, Raiders of the Lost Ark. Unlike other prequels, that one is not telling a background story to explain how the situation in the first film came about, it is just a previous adventure of the main character.
It is more common for a prequel to explain the backstory to the original work, show how the situation at the start of the original came about, and flesh out things referred to as past events. The Silmarillion, Tolkien's attempt to emulate creation mythology, serves as a grand scale prequel to The Hobbit and The Lord of the Rings, explaining not just where the One Ring and Sauron came from, but the creation of Middle-Earth, its peoples, and more background to the world than most sane people could ever want.
Expanded universe situations can lead to works with an earlier setting being named a prequel to the other work when they begin to be crossed over. This can get quite silly: The Wikipedia article lists Predator as a prequel to Alien, purely on the basis of Alien vs Predator. Though the expanded - and combined with ludicrous glue - universe of these two franchises certainly allows this view, it's not really correct, since Predator was made without any reference to Alien (Predator 2, on the other hand, has a sneaky visual reference to the two film series being part of the same continuity). Alien vs. Predator and its sequel are, however, sequels to Predator, and prequels to Alien. They serve as prequels to the Alien films because together they provide some background to the oft-mentioned Weyland-Yutani Corporation. The word used to describe the act of creating this kind of appalling mess is "retcon" - though the Wikipedia page is more likely the result of what they call "fancruft". If you think the Alien/Predator example is convoluted, have a try at unravelling the relationships between Asmiov's Foundation-Robot-Empire works.
The abuse of the word "prequel" comes when people use it to refer to any entry in a series that comes before the installment they're currently talking about. As an example, I have seen Alice's Adventures in Wonderland referred to as a prequel to Through the Looking Glass. This also happens with films - in fact, I would say it happens far more often with films due to their broader appeal. Usually this happens because people start talking about the sequel and then want to name the earlier work - and the word prequel springs to mind instead of terms such as "predecessor", "previous", "the first", or in the case of numbered titles, "the original".
It's fairly obvious that there are people who just don't understand the proper use of the word, but I notice it doesn't happen quite so often with titles including numbers - the first film (it's usually films that have numbered entries, but computer games are prone to the same naming systems) will simply have "one" tacked on by the speaker to denote which entry in the series people are talking about. Of course, there are exceptions... The most shameful, disgraceful abuse of the word "prequel" is seeing 2001: A Space Odyssey referred to as a prequel to 2010: Odyssey Two.
Just to make the situation ever better, here's what's going to happen soon: The book titled The Hobbit is already said to be a prequel to The Lord of the Rings (it's not). But the film called The Hobbit is going to be a prequel to the Lord of the Rings trilogy, since it is being made later! I'm sure this will further confuse the matter in the minds of casual film viewers, and further infuriate me when I read reviews.