In fiction, the physical setting is where a story takes place. Stories also have a chronological setting, or the time when the story takes place, and a social setting.
A story's physical setting is much like stage scenery from a play. It can be general, such as "a tropical ocean," or very specific, like "1600 Pennsylvania Ave. NW, East Room Podium."
Shirley Jackson uses a vague physical setting deliberately in her classic story "The Lottery." She wanted the story to feel possible anywhere. Jack London's "To Build a Fire" has a more specific setting that is critical to the plot. J.R.R. Tolkien went to great lengths to carefully develop his imaginary physical setting in "The Lord of the Rings" so that it felt real.
The physical setting can be unimportant, or it can be the primary source of mood, symbolism or even conflict.