The standard answer to this question is that our brain picks up the tiny difference between the times at which a sound arrives at each ear, and from this figures out where the sound is coming from. But simply selecting points with a particular difference in their distances will yield an entire conical surface of possible origins. Distance, I suppose, can be judged from the softness of the noise, but how do we tell which of the possible directions the sound is actually coming from?

I've heard that your brain calculates the position by the time difference between the sound reaching one ear and the other. However, i'm sure this is wrong! If there's a loud bang a short distance behind you, how do you know it was behind you? The sound would reach both ears at the same time, so the source could be infront of you, or even above you!