I know your question has already been basically answered, but to answer the side question "What does AI stand for?" It stands for "Artificial Intelligence". Just like Fable said, that's where the computer will make the decisions for you based upon any given situation. With the AI on, depending upon the Script assigned to each NPC, the computer may decide to attack a character outside your party that should not be attacked thus ruining a quest. That's why they advise that you turn the AI off, so it allows you to make the decision yourself.
ps: no intention of stepping on Fables toes, just expounding a bit further.
