When you say wi-fi through Sky, you mean you have a little box with lights and an antenna on it right? If so, that is a wireless router. In order that you can get internet access on your iPod, it transmits a signal with a network name on it, which showed up on your iPod when you searched for a wireless connection. Still with me?
WEP and WPA refers to the type of security that your wireless broadcast uses. Say for example your wireless signal is called SkyBroadband. Well, just as your iPod can see that signal, so can any other iPod or wireless enabled device in range of your router. Does it have a password that protects it? I.e. when you first connected to it on your iPod, did you have to enter a passcode to access the network? If not, then anybody in range of your wireless router can use your internet connection through that signal.
The best thing to do is consult the manual that will have come with the wireless router. It is very easy to check if it's using a secure mode, and if so, which that is. Most are pre-configured to use WEP straight out of the box, but this is very easy circumvent, which is why I recommended WPA or WPA 2.
Basically, all it does is "lock" your wireless signal, so that only people who know the password can access your internet connection, and only people who have that password can make any sense of the information that is passing between your decide (the iPod) and the router.