The general mechanism of an air compressor is a piston or rotary Water Lubricated Air Compressor component (e.g. rotary screw or vane) that draws in atmosphere, which is compressed into a storage container. Naturally, because the piston or rotary component needs to move regularly and smoothly for this to work, it generally must be lubricated.
In a lubricated air compressor, there is lubricating oil which will keep the piston or rotary component running smoothly without damaging the mechanism. The lubricant also really helps to dissipate high temperature and maintain air compression efficiency.
Oil-totally free air compressors also use a piston or rotary element, however they get around the lubrication problem by coating the compression component with a pre-lubricating material like 
Teflon. Some oil-free compressors may also use water in place of oil for the lubricating and cooling process. These alternate materials protect the pump and allow the mechanism to move smoothly with no need for any oil-based or synthetic lubrication.