To see the magic simply open TextEdit, create a new document (if you are not already presented with one) and add the following text to the document:
watch: this: space:
Now, select the text, copy it and save the file with the selected text as the file name.
The dialog magically converts the colons to hyphens (-) to ensure that you don't have to go through he whole 'This filename is not allowed' error cycle needlessly. Brill.
The reason for the substitution is that OS X prohibits the use of colon characters in file/directory names because this character is used to represent a directory in the HFS+ file system.
According to the HFS+ spec you can use any Unicode or ASCII (including NUL) characters. OS APIs may limit some of these characters for legacy reasons.
I love subtlety.