A colony is a type of settlement that has less than 1000 population. It is partially settled, but not yet regarded as a city. The owner cannot build any city upgrades, troops, or ships there, but can do more colonization to increase its population. The owner may also attempt religious conversion, although this is usually a waste of money, since further colonization will itself convert the colony.
Coastal colonies may have a port, and thus resupply naval units. Regardless of whether a colony is a port, it also creates national waters in any adjacent sea zones. Colonies also raise land supply.
A colony can contain uncivilized natives. Natives will automatically be incorporated into the colony's population when it reaches 900 (level 9). Natives have an aggressiveness factor, and may form an army and take over or destroy the settlement. Native-controlled colonies fly a white flag with a black steer's head, but remain under the ownership of the colonizing country. Natives can be beaten down or destroyed by land troops.
Whenever a colony is successfully expanded with another colonist, and the result of the operation is still a colony (<1000 pop, or <900 pop with natives present), the colony is converted to the primary state culture and the state religion of the country which colonized. In general it's a good idea to convert the religion of any colonies you take as fast as you can, because otherwise they are a valid target for a religious conversion random event, which would be much better targeted elsewhere.