Within the file .idea/workspace.xml the following can be found:
...
This option controls how classpath is passed to the JVM: via the command line, or via a file. Most operating systems have maximum command line limit, when it's exceeded, IDEA will not be able to run your application.
When command line is longer than 32768 chars, IDEA suggests you switching to the dynamic classpath. Long classpath is written to a file, then read by the application launcher and loaded via system classloader.
If you are interested in the implementation details, you can check IDEA Community edition source code, JdkUtil.java file, setupJVMCommandLine
method.
A side effect with IntelliJ 9.0.4 is that after turning the option on, the class path is no longer complete.
In my case the option was turnend on after i choose "yes" in an error dialog when running all unit tests in a specific package. The error message reads "Command line is too long. In order to reduce its length classpath file can be used. Would you like to enable classpath file mode for all run configurations of your project?"
After this some tests failed because the needed classes from other modules, which were than missing in the classpath.
I found no dialog where i could switch it back. I had to edit the .iws file manually and switched the dynamic.classpath option back to "false".