Internal dialogue is where you have your character's thoughts written out. Internal thoughts that are italicized in a novel will usually be underlined in manuscript format. And while all dialogue is character driven, internal dialogue takes that to an even a higher level. Why? Because internal dialogue is what you would think, but would probably never really say. In other words, internal dialogue is never censored. Internal dialogue can be very useful, especially when your character is saying one thing but really thinks another. See the following two dialogue excerpts:
“Isn't he a sight for sore eyes?” Candy moved the blanket from the infant's face. “You can say that again,” Becky answered. That proved it. Love really was blind.
“You are going to come visit me, aren't you?” Tom asked. Sandy smiled. “You better believe I will.” Right after they lower my casket into the ground.
Internal dialogue is only used when you are in that person's point of view. To use it otherwise would mean you are jumping POV and that can confuse the reader.
Most internal dialogue is written in first person — even when the book is written in third — because the character is talking to herself. However, some authors stay in third person when using internal dialogue. The best rule of thumb is to use what sounds natural.
While the use of internal dialogue is a great key to characterization, and enhances deep POV, too much of it can distract from the story. For some authors, writing internal dialogue comes naturally and works very well with their writing voice. For others, it feels and reads forced. The best way to learn to write internal dialogue is to study other authors who use it regularly.