The Milo game actually involves two characters: Milo (or Miley, the girl) and Kate, his dog. In effect, this will in some ways share certain elements with the Sims games in that Milo's happiness and evolution will depend upon the help and opportunities you provide. Unlike The Sims, your interaction will be seemingly "one-on-one" with Milo - you'll talk to him, and he'll respond.
Molyneux makes no claims about Milo's sophistication. In the interview, he says,
"Milo can recognise the emotions on your face and the emotions in your voice. He can recognise certain words you say. You can have conversations with him, you can read stories to him. We're trying to bring all these things together. Some of them are tricks - I'll be absolutely honest with you - to make you believe Milo's real."
At Molyneux's suggestion, the reporter tells Milo a random joke. Milo giggles. But did he "understand?"
"Now, he didn't really understand every word you said, but from the tone of your voice he guessed you were telling a joke."
While Milo is incredibly sophisticated, it's ability to "understand" is really a matter of reading audio and visual clues from the player, rather than understanding in great detail the meaning of the communication - much the same way that a good fortune teller can anticipate a proper response from facial expressions and body language.
If you're interested in the "Milo Project," this is interview is a good place to explore the concept. You can also visit the website for Lionhead Studios, developer of Milo. There's not much there about Milo, but they have set up this public forum.