A "dyke" is a female homosexual or a low wall built to prevent floods (this second kind is also spelled "dike"). Some people suspect there's a connection between the two definitions: that women who were not interested in having sex with men might once have been compared, with disgust, to a stone barrier.
On the other hand, Boudicca, a Celtic warrior queen in Britain in the first century AD, could have inspired "dyke." Or the 19th century black women who dug ditches in the American south and were known as "bulldikes" (or even the black male laborers of that time called "bull dicks" by white plantation owners).
It's all mostly a game of guessing. Lesbians by any name were mentioned very little in print until about 1920, so it's hard to say when the word "dyke" hit spoken english.
When it did hit, it meant--and still often means--a particularly "butch" lesbian: with stereotypically "masculine" clothes and appearance. ("Butch" is actually about a lot more than looks; it was a full way of life in the underground lesbian culture of the early to mid-20th century.) In African-American slang of the 1920s, to be "diked up" was to be "dressed up" and came to refer to women dressing butch.
In the '60s, activists fighting discrimination against gay people got their first mainstream notice. And after that, the word "dyke" acquired, for some lesbians, a sense of pride.
Like lots of names people call each other, the word changes a lot with context. Shouted at someone in school or on the street, it's mean--and is meant to make a girl or woman think she is not being friendly enough to men. As a less-bookish-sounding alternative to "lesbian," it's mostly just descriptive.
Used by present-day lesbian activists and media--Dyke TV or Dykes to Watch Out For, for example--it's descriptive, but with a slightly rowdy we're-here, get-used-to-it edge.
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