THE STORY SO FAR: Orsino sent Cesario (who is actually Viola and is in love with him) to woo Olivia on his behalf. Olivia fell in love with Cesario, who returns to Orsino to find him still moping about self-indulgently, wallowing in love-sickness.
The interplay between Viola and Orsino in this scene is adorable. She matches all his posturing with genuine, eloquent sentiment, and you can see him starting to think more seriously about his little pretty "boy" friend.
Incidentally, in my favorite TV program of all time, John Barton's Playing Shakespeare, Barton rehearses this entire scene with Judi Dench and Richard Pasco. It's well worth a watch over your lunch break or something. Here's a sub-par YouTube clip of it:
Dramatis Personae | 1.1 | 1.2 | 1.3 | 1.4 | 1.5, part 1 | 1.5, part 2 | 1.5, part 3 | 2.1 | 2.2 | 2.3, part 1 | 2.3, part 2 | 2.4, part 1