Microcontroller core voltage
You'd be better off reading the datasheet instead of the user guide, but:


  We are providing 3.3 to 5V and we place an NPN outside to get the 1.2V which is then fed to the Micro pins.
  
  
  is this correct?
  


Yes; the internal regulator generates 1.2V for the core.

The fact that these 1.2V are available externally is mostly so that you can (have to) connect decoupling/stabilizing capacitors, which can't be integrated into a silicon die.


  How does this work?


Linear regulator. Just like you can buy an LDO chip, that LDO can also be integrated into a microcontroller silicon chip.


  If this is true, then the Micro Vcc is 5V only, right?


No. How do you come to that conclusion? The datasheet clearly lists all the 3.3V supplies you need.


  And how by placing a NPN transistor and giving 5V to its collector, we get 1.2V at the emitter? How does the transistor do this? 


That's basically the question of "how do I build a linear regulator with a NPN transistor". There's simply a device measuring the voltage at the emitter; if it's lower than it should be, the base voltage of the transistor is increased, if it's too high it's decreased, so that the differential resistance of the collector-emitter junction is "just right", so that the current draw leads to exactly the voltage drop across that junction that leads to the correct output voltage.

You can imagine (it's not going to be a full opamp inside the chip, but the principles apply) it working like:







simulate this circuit &ndash; Schematic created using CircuitLab

As a matter of fact, the Base-Emitter voltage of a standard NPN is usually pretty fixed (~0.7 V) for all relevant current draws, so that there needn't be a specific sense pin to sense the emitter voltage, if one can sense the base voltage relative to ground.