My clients often ask me if it's better to set up their blog in a subdomain or a subfolder. Before I lose you, let me explain the difference between a sudomain and subfolder then I'll talk about which method is better for your search ranking.
A subdomain is a prefix added to your URL that differentiates your blog from your website. For example, a subdomain for your blog would be http://blog.domain.com which makes your blog look like a different site from your website which is http://domain.com.
A subfolder is added to the end of your URL which separates your blog from your website. Your website is located at http://domain.com while your blog is located at http://domain.com/blog.
In the past, Google treated subdomains as a separate website so the content in your subdomains didn't contribute to the search ranking of your primary domain. The content in http://blog.domain.com counted as one website and the content in http://domain.com counted as a separate website. Google ranked both sites separately.
At the same time, content located in http://domain.com and http://domain.com/blog counted as one website so it was beneficial to your search rankings to use subfolders instead of subdomains.
Recently Google decided to consider subdomains the same way as subdomains with respect to your search ranking. Now it doesn't matter if you use subdomains or subfolders for your blog. Both methods will benefit your search ranking.
If you want to read more about the recent Google update visit http://googlewebmastercentral.blogspot.com/2011/08/reorganizing-internal-vs-external.html