Drag: Wayland does replace the X server at one level of the stack. It can in time completely replace the X server: you don't have to run an X server at all with Wayland, unless you want to run existing X clients.
Assuming Wayland actually gets to a usable and complete point, and the design is proven solid, then developers can start porting apps (or toolkits, really) to Wayland's native protocol. Assuming all of your apps are ported, there'd be no need for you to have an X server running at all. You could fire up an X server on-demand for apps that need it, such as old closed binaries or old unported apps. That scenario is probably a good number of years away, though.
If you read the FAQ Kristian posted, that's all spelled out for you. It's pretty clear and informative.
The only thing I don't see answered (plz to answer Kristian kthxbai) is whether or not Wayland's protocol intends to support remote connections; if not, X would remain useful indefinitely for remote client support, but not for local clients.
The point of Wayland is essentially that 90% of what X does isn't necessary any more: all of the hardware setup is done in the kernel, all of the rendering is done in the clients, and all of the input events are handled by unified driver interfaces. Nested windows are considered harmful these days, the mandatory core X drawing protocol is essentially unused, and even RENDER is being replaced by clients doing rendering straight to pixmap buffers using GL. The only thing X is really needed for (aside from network support) is the functionality that Wayland provides, but Wayland does it without all the legacy protocol requirements. In the short term, Wayland is only useful as an X session multiplexer. Long term, it has the potential to make X unnecessary for most setups.
It's a really neat total redesign of the graphics stack in face of KMS/GEM/DRI2/EGL, and because X can so easily be run as a nested client, it can be done in a very transition-friendly manner so there's no "port or die" mandate like so many other software replacements force on developers. Pretty cool.
