Armour is your main source of protection against the attacks of skulls. It is comprised of defense points (also interchangeably called 'armour points' by the game). Increasing your armour value (by buying better equipment at the shop or applying armour-boosting enchantments) will increase the maximum amount of defense points you can have. As enemies attack you, your armour absorbs part of the damage and some defense points are deducted from your reserves. It works as follows:
If enemies deal less damage than you currently have defense points, you do not lose any health. For each point of damage absorbed, there is a 50% chance that a point of defense will not be deducted (this chance can be improved to up to 90% with armour durability upgrades). So if you have 30/40 armour points and enemies attack with 10 damage, you will not lose any health and, on average, your armour points will drop to 25/40.
If enemies deal more damage than you have defense points, an amount of damage equal to how many defense points you currently have is absorbed, the rest is dealt to your health. There is still a 50% base chance that each point of damage absorbed will deduct a defense point. So if you have 30/40 armour points and enemies deal 65 damage, your health will drop by 35 points, and you'll remain with around 15/40 armour points.