Let me try - I'm not an expert at Silverlight development, so bear with me if I say something that doesn't apply to Silverlight :-)
As Matt Davis mentioned, the "usual" use case is this: you add a service reference to a given service URL. In doing so, Visual Studio (or the command-line tool svcutil.exe) will interrogate the service and grab its metadata - information that describes the service, all the available methods to call, what parameter they expect etc. From this, it will generate a class for you (usually called the "client" or "client proxy"), which you as a client (=service consumer) will use to call the service. You can have this client proxy class generated inside your "normal" Silverlight client project, or you could possibly create your own "service adapter" class library, esp. if you will be sharing that client proxy code amongst several Silverlight projects. How things are structured on the server side of things is totally irrelevant at this point.
As Matt D. also mentioned, if you do it this way, you're getting copies of the service, its methods, and its data, in your client - those are identical in structure to what the server has - but they're not the same type - you on the client side have one type, the server has another (the fields and properties are identical though).
This is important to remember since the whole basic idea of WCF is message-passing - all that connects the client (you) and the server (the other end) are the messages and their structure - what method to call and what values to pass into that method. There's no other link - there's no way a server can "connect" to the client code and check something or whatever. All that gets exchanged is serialized messages (in text or binary form).
If you do control both ends, you can simplify things a bit - you can physically share the service contract (the definition what the service looks like and what methods it has to call into) and the data contract (the description of what data is being passed back and forth) on both the server side as well as the client side. In this case, you won't be adding a service reference, you won't be duplicating the service and data definitions, so things are a bit easier (but it only works if you're in control of both ends).
In this case, best practice would be to package up all that describes the service (the service interface with its methods and the data contracts) into a separate assembly (class library) on the server, which you can then copy to the client side, and reference directly from there (like any old assembly you might have). So in this case, you would typically have at least three projects in your solution:
- your actual Silverlight client project
- the website or web app hosting your Silverlight control for testing
- the service interface assembly, which contains the service and data contracts
So there you have it - I hope I covered all the basics of what's going on, and why you would want to do one or the other thing. If you need additional info, don't hesitate to comment on this posting and let us know!
Marc