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What is the virtual 8086 mode?

It's a feature introduced with the 80386, to make possible to run real mode applications in a transparent way, while the processor actually works on protected mode. Indeed, the previous 80286 protected mode suffered two limitations: a poor compatibility with real mode applications and the inability to revert to real mode without reseting the processor. As a result, to maintain compatibility with existing programs, users simply preferred to use their 80286 on real mode (with all its critical limitations: most notably the direct access to only 1024/1088 Kb RAM, and 640 Kb conventional memory). The virtual 8086 mode succeed to impose the protected mode, since the software compatibility was greatly improved (in fact, there remained some issues, but it was globally much better than 80286 mode).

How Windows can manage it?

Windows/386, Windows 3.x, Windows 9x and even 32-bit x86 iterations of Windows NT support virtual 8086 mode. That's why older MS-DOS applications can run on these systems without full emulation, although these operating systems obviously run on protected mode (if the result is often disappointing on Windows NT, especially on DOS games, it's due to strong access restrictions to the hardware imposed by NTVDM). Moreover, these DOS programs are isolated on distinct virtual machines called 8086, thus potentially improves the stability and multitask management. Put simple, the 80386 protected mode, which added virtual 8086 mode, brought many advantages and no drawback in comparison to 80286 protected mode. That earlier mode was rarely used by Microsoft (only OS/2 1.x, Windows 3.x and Xenix have supported it).