There's actually a very good Apple document on the security of iDevice hardware and iOS (various versions) which explains just what is and what isn't covered.
In summary, the device is encrypted using keys generated at user install (new, or after a factory reset) and the private keys are kept in a tamper-proof chip. So you cannot open an iPhone, strip out the chips and read the storage in another device.
Once you set a password, it's linked with the keys and grants you access to the content.
As always, if you've got the keys, you can get into the vault. If you then put a hole in the wall of the vault (e.g. jailbreak the phone) then don't be surprised if someone else can see in.