Here is an excerpt from a site, that seems to clear your question:
"the first one creates a web site using the web site project model (default in VS2005) which is based on that you don'tT have a standalone project file, but project contents are defined by physical directory structure. Basically a web site project has also slightly different compilation model, for example not everything in the project is necessarily built into single assembly, and you don't necessarily have an explicit precompilation step (e.g a build in Vs) but pages are compiled individually when they are requested
The second one creates a web application with web application project model, where all the contents is specified in a project file, and also explicit precompilation step exists. It's similar to the model which existed in VS2003."
And http://www.techbubbles.com/aspnet/aspnet-website-vs-web-application-project/ is the TechBubble article that throws more light at the two Project options.