@ami500
1. Why is it referred to with some utilities as "restoring factory settings"?
Probably the disk is wiped with 0 and initial MBR is written. This is likely to be the "factory setup", so the tool restores it. It only restores the logical layout, not physical.
2. Why did it "fix" the bad sectors on my deathstar before the physical damage became too great for it?
Usually hard drives map out bad blocks automagically without ever letting the OS know about it (except perhaps thru SMART). Having bad blocks is normal to some extent, and each and every hard disk has them, no matter how high quality.
However, when the problems grow too severe, the error is actually passed to the caller aswell. If the drive ever report physical error to OS, it means the disk is seriously hosed, and needs to be replaced. Recovering it by "format" might help temporarily, but you should not use the disk for storing any important data, as the problem is likely to get only worse. Eventually the disk will go permanently dead.