What exactly does `update-alternatives` do?

It updates the links in /etc/alternatives to point to the program for this purpose. There's lots of examples, like x-www-browser, editor, etc. that will link to the browser or editor of your preference. Some scripts or system tools may want you to edit a file manually (e.g. configuration conflict in dpkg) and they'll look into the alternatives to give you the editor of choice. For java, this is the Java runtime environment - Oracle's, OpenJRE, etc.

The links in /etc/alternatives are just symbolic links. You can see them using for example

ls -l /etc/alternatives

Moreover, the regular /usr/bin binaries are also symlinks. E.g.:

ls -l /usr/bin/java
  lrwxrwxrwx 1 root root 22 Aug 14 10:33 /usr/bin/java -> /etc/alternatives/java
ls -l /etc/alternatives/java
  lrwxrwxrwx 1 root root 46 Aug 14 10:33 /etc/alternatives/java -> /usr/lib/jvm/java-6-openjdk-amd64/jre/bin/java

So, no PATH has to be modified. It just uses symbolic links.

While @gertvdjik's answer is a good explanation of how alternatives work at the lower level, it doesn't explicitly say how to revert the original state.

I find it easier to use the corresponding GUI galternatives which is available as a package. To install it, just run:

sudo apt-get install galternatives

Then managing alternatives becomes much easier. For java in particular, you have a lot of auxiliary binaries which you'll have to update and it's faster to overview them in the GUI.