Auto-wrap works like the auto-fill mode in Emacs. When pressing <space> or <enter> after the cursor is past the wrapping column, that line is wrapped onto the next.
Like in the Emacs function, auto-wrap does not attempt to re-flow the entire paragraph; it only adds a break in the current line. It's handy when typing new text, but won't automatically fix a paragraph after inserting/removing text. For this you can always do a standard alt+q after making edits.
Auto-wrap is disabled by default, but can be enabled with the Rewrap > Auto Wrap: Enabled setting. This setting (rewrap.autoWrap.enabled) can also be set per language/document type.
Even when enabled, it will only activate within comments in code files, not on code lines, so it's usually ok to leave it enabled.
To temporarily enable or disable auto-wrap for the current document, you can use the Rewrap: Toggle Auto-Wrap command in the command palette.
To help keep track of when auto-wrap is on or off, there is a small (optional, but on by default) icon/notification in the right of the statusbar, that shows the auto-wrap state for the current document. It has 4 states:
(normal): on, enabled in settings
(hidden): off, disabled in settings
(orange): temporarily enabled, from toggle command
(gray): temporarily disabled, from toggle command
Hovering over this icon will give more information.
If you don't like the icon, you can hide it, or change the Rewrap > AutoWrap: Notification setting to text. Then it will instead show a brief text message in the status bar for a few seconds whenever auto-wrap is toggled on or off.
There's no default keybinding for the toggle command, but you can add one, eg shift+alt+q, by binding to the command ID rewrap.toggleAutoWrap in the Keyboard Shortcuts editor.
Auto-wrap is turned off by default. Turning it on is global: it affects all documents edited. In code files, only comments will be affected, so it's pretty safe to leave it on.
On the Edit menu, under the Rewrap Lines command, is the Toggle Auto-Wrap item.
The check-mark shows the status and a brief statusbar message is shown when turning on/off.
To add a keybinding for the toggle command, go to Tools -> Options, then Environment -> Keyboard. In this dialog pane search for the command Edit.ToggleAutoWrap and you can assign a shortcut key to it.