What is disavow link and how it works on SE?
Google's Disavow Tool is the latest webmaster tool that allow website owners to request on google removal of unnatural and low-quality links that may harm your website's ranking. However, this tool might also harm your website if used incorrectly. Use it wisely, it is a productive asset for your SEO.
Well, Google Disavow tool is used to disavow links which you feel are spammy. And one more thing disavow tool is not the thing which you can play with because using it in inappropriate way can results in bad traffic. I would not recommend using it until or unless there's no way out like @WeboutGateway has already defined when to use disavow tool out !
Thant is very useful tool to report spam back link to Google. You can manually check your back links and found spam back links then create a list of these typer links and after completing submit to disavow tool. Google will never index these back links and your website never got penalty.
If your site received a Penguin penalty, then you will need to review the quality of your backlinks and then if ever you found some bad links, you then use the Google Disavow Link Tool to inform Google about these bad links.
Well @rajnishk418 Actually Google disavow tool isn't used to report spam backlink to Google rather than its used to tell Google that while ranking me over the SERPS please don't consider these links. (Like you said in the 2nd part of your answer). :)
If you have links to your site which you think are spammy and hurting your ranking in Google search, you can tell Google not to count those links so they won't hurt your ranking anymore. You need a Google Webmaster Tools account to do this. Also you need to put the links to be disavowed in Notepad on PC (I forget what the equivalent is called on a Mac) using a certain format. On my blog I have lengthy detailed how-to posts on finding bad links and disavowing them. I made this blog to help beginners do SEO. It is a bit of a difficult process so if you need support or have questions feel free to email me. I'll link to the first post below. Then you can find the rest on the blog.
How to Find Bad Links
How to Remove Bad Links Part One - Ask for Removal on the Site Itself
How to Remove Bad Links Part Two - Use Whois to Find the Owner
How to Remove Bad Links Part Three - Create the Disavow Tool Text
You can easily find from google how to use disavow webmaster tool.