This is dictated by the /etc/nsswitch.conf file's hosts directive. For example, on my system:

hosts: files mdns4_minimal [NOTFOUND=return] dns 

Here, files refers to the /etc/hosts file, and dns refers to the DNS system. And as you can imagine whichever comes first wins.

Also, see man 5 nsswitch.conf to get more idea on this.

As an aside, to follow the NSS host resolution orderings, use getent with hosts as database e.g.:

getent hosts example.com 

This is dictated by the NSS (Name Service Switch) configuration i.e. /etc/nsswitch.conf file's hosts directive. For example, on my system:

hosts: files mdns4_minimal [NOTFOUND=return] dns 

Here, files refers to the /etc/hosts file, and dns refers to the DNS system. And as you can imagine whichever comes first wins.

Also, see man 5 nsswitch.conf to get more idea on this.

As an aside, to follow the NSS host resolution orderings, use getent with hosts as database e.g.:

getent hosts example.com