Understanding how One-BJT CW transceivers work
Oh man, there's so many things going on with that circuit...
The circuit is a Colpitts oscillator, always.
With the key up, the strength of the oscillation is severely limited by R2.  This does two things: it keeps you from getting nice QSL cards from the FCC for spurious emissions (maybe), and it lets signals coming in the antenna affect the strength of oscillation.  Note, however, that you still have an active oscillator connected to an antenna, so it will be radiating.  It's kind of a regenerative receiver with a crystal in it.  Received signals are rectified by Q1 (cringe) and appear in the headphones.
With the key down, oscillation amplitude goes up, and C2 is partially shorted by L1, and -- presto! -- you're transmitting a fairly strong signal.  Because L1 is now active in the circuit, the frequency of operation shifts slightly -- this means that someone talking to you on your frequency will be received as a tone in the receiver.
(Edited because I was originally looking at the wrong schematic)
At any rate - have fun, and stand in front of he mirror practicing saying &quot;yes sir and/or madam, I will stop using that transmitting equipment immediately!&quot;.