The way that works, for those who don't feel like diving into the combat mechanics section of the manual, is thus.
A sword (or point of defense on the unit screen) is a 30% chance of dealing 1 hit of damage. A +1 to Hit boosts that by 10%; thus, after +7 to Hit is achieved (it's not too hard if you get a hero with the innate that boosts their to-hit chance and hand them a weapon that does the same) means that, assuming no hit penalties get applied, you're dealing 1 point of damage per point of attack.
A shield is a 30% chance of blocking 1 hit of incoming damage. I can't recall any effect in the game that boosts this 30% chance aside from Lucky.
A cross is a 10% chance of resisting an incoming effect; therefore, with 5 crosses, you have a 50% chance of blocking an incoming effect, and with 10 crosses, you have a 100% chance of blocking an incoming effect.
Some abilities, of course, can ignore crosses of resistance; it will be listed in the spell description or in the skill's description whether it gives a saving throw penalty.
Thus, in the later game, there are diminishing returns on some stats. Anything past twelve or fourteen crosses begins to become pointless, since there's not really much that can break through that. Anything past +7 to Hit is similarly more or less pointless, since there are very few enemies with a hit-reduction (I think some Death or Sorcery magic may apply it, but not sure). Defense increases also begin to lose their effectiveness later in the game, because it stays at a flat 30% chance-per-shield, as opposed to the scaling to-hit bonuses that attackers will receive as they level or as you begin to encounter better Fantastic Creatures.
Hope this helps!

10 extra defense means that on average you'll take 3 less damage. How does that lose effectiveness?
I like having heroes with enough defense to go toe-to-toe with the toughest creatures and come out with barely a scratch :)

One important thing to note is that the combat stats are per figure, not per unit. This means that a unit of eight spearmen with one heart can take a total of eight points of damage before being wiped out. If our spearmen also have an attack rating of one sword, it means that the unit attacks eight times per round with a strength of one sword.
Naturally enough, a unit with multiple figures can start losing those figures as it takes damage. This, of course, means that if our unit of eight spearmen loses two figures, it will only get six attacks per round instead of eight. Typically, incoming damage is applied to one figure at a time and rolls over to the next figure if the first one dies, but some attacks (such as the fireball spell) will strike multiple figures at once.
There's no special mechanic to recovering lost figures - they return as the unit recovers its health.

What I meant about defense losing effectiveness was the fact that 10 extra defense means, on average, 3 blocked hits... but for an experienced unit, 10 extra swords can mean five or six hits on average. It starts taking more shields to block the same number of attack points, and that's before considering armor piercing (ignore half of defense), Eldritch Blade (if I'm not mistaken, reduce chance of defense to 20%) and Illusory (illusionary attacks ignore all defense if the target is not Immune To Illusions).
Anyway, to-hit bonuses are much more common than to-defend bonuses, since there's something like one or two of those in the game. Defense never itself goes down in value, but its effectiveness in comparison to attack decreases as the game goes on.

I always wondered about this...
Why does it seem that units take less damage if they are defending vs. if they are damaged as part of a counterattack? Conversely, units seem to deal more damage when they attack as opposed to when they counterattack.

Wait, aren't you contradicting yoruself here? If a unit takes less damage when it is defending, that means the attacking unit is doing less damage when it is attacking. Doesn't it?

Incredible. I thought the effect was non-existent. You are first ever to report this.
Try reading this:
http://www.dragonsword.com/forum/phpbb/viewtopic.php?t=12

There are these special abilities that only apply when attacking right? For example these red chaos hounds, they are devastating when attacking so I see that I attack always first.
Those reds are the best unit in the game I think, not the strongest, but the most important if you are chaos.

Does anyone an unambiguous answer for whether magic ranged attack damage is reduced by shields or resistance? If it's resistance, does every point have a 30% chance of blocking a single point of damage (like shields), or how is it calculated? The manual makes pretty much no mention of magical ranged attacks so I'm somewhat confused, after all they are affected by magic immunity unlike projectile weapons. Resist elements is pretty much the only spell that clearly states it reduces the damage done by magical ranged attacks, although I'm not sure how much.

As for units containing multiple figures, how is "overflowing" damage calculated? E.g. let's I have a group of halfling slingers with a ranged attack of 1 (my numbers could be off) with 8 figures and they attack a group of spearmen with 2 shields and 1 health also containing 8 figures. The halflings get somewhat lucky and only 4 attacks miss. The first spearman fails the rolls for both of his shields and dies. Does the second spearman also get to roll for both of his shields? Or am I completely off and initally the spearman unit has a total of 16 shields, possibly dropping to 14 if the first spearman dies? If so, do the spearmen get to roll a total of 14 shields, again? The latter option seems rather unlikely since it would make any half-decent unit pretty much immune to powerful single-figure units like heroes.

As for resistance, is there something I'm missing? According to the description any unit with 10 resistance should be completely immune to spells that don't have a resistance penalty in their description (assuming they're resistible in the first place), yet I could swear this is not the case. Not only do units with way more than 10 resistance get affected by spells, units with less than that seem to get affected way more often than they should. I know heroes can have items with -spell save which supposedly reduces the target's resistance by the shown amount for the purposes of resisting a spell cast by the hero, but you (the wizard) have no such possibility. Or is this all just a huge confirmation bias?

Also, what exactly do the numbers in breath/throwing/gaze attacks mean? Does "Throwing 10" mean the attacked unit takes a strength 10 physical (reduced by successful shield rolls) attack? What about hit chances? Do such abilities always hit or do they have the standard 30% to hit chance? What about clearly magical abilities like storm breath? Are they affected by shields or resistance (if the latter, how?)?.

Lastly, how does the halflings' "lucky" trait work? Obviously it gives them +1 to hit and I've heard it also gives them a +1 chance to defend, i.e. 40% per shield. Is the latter true, and does it have any additional effects? I'd assume it also gives them one point of resistance.

Oh, and how is ranged distance calculated for to-hit purposes? The manual states that for a distance of 1-2 tiles ranged attacks have a 30% chance to hit. If A is attacker and B is defender, which of the following is a distance of 1 tile?

[A] [ ]
[A] (most conventional ranged attackers would be unable to use a ranged attack in this situation)
Also, if a ranged attacker has +1 to hit does that mean at 1-2 tiles the chance to hit is 40%, at 3-X (can't remember what exactly) it's 30% and beyond X it's 20%? That's what I'd assume but the manual was somewhat unclear about +to hit with ranged attacks.

Oh darn it, there's one more. What exactly are the bonuses of magic/mithril/adamantium weapons respectively? I know they allow you to attack creatures (almost) immune to normal weapons, but supposedly they also give extra attack power and perhaps more importantly, +to hit.

Well, that turned out to be a bit longer than I thought. I've been unable to find non-vague answers to these questions.

Question A: Defense (Shields) blocks magic ranged damage. This also includes combat spells like Fire Bolt. Shields also apply to "magical" things like flame breath and the like. Resist elements gives +3 shields that only apply to magical ranged attacks.

Overflowing damage is calculated pretty simply. The first figure in the stack takes the attack, and applies the unit's shields score (in your example, 2 shields) at a 30% to-block rate to reduce damage. After that, he takes the damage. Any damage over what it takes to kill him spills over intact onto the next unit, which then rolls its own shields and takes what's left over.

On resisting: There may be some confirmation bias here. I can't speak to this with any certainty so I'll pass over it to avoid passing bad info.

The numbers on special attacks: Breath and throwing attacks occur before regular combat, allowing the unit to launch an attack of the listed strength on the enemy. For example, a unit with thrown 1 launches a strength 1 physical attack (per figure) on the enemy before they engage in actual combat and their swords come into play. I'm not positive whether to-hit comes into play here... I'd have to do some testing.

Lucky gives halfies +1 to all rolls. This equates to a +1 to hit, +1 resist, and, yes, makes their shields have 40% chance of working instead of 30%.

Ranged attacks suffer a hit penalty based on distance, yeah. Someone adjacent or one space out from adjacent gets no penalty, someone at 3-4 spaces away gets a -1, and it goes up on that pattern. Units with the Long Range special (catapults, etc) have this capped at -1.

Magic weapons give a +1 to hit and bypass weapon immunity. Mithril and adamantium give an additional bonus of X swords to the unit; I think it's like +1 and +2, respectively, but you can see if you look at an unenchanted unit with adamantium, the bonus swords are orange highlighted.