I understand the concept of the fediverse but what I'm struggling with is the instance part. I know an instance is a spun up server, and I'm assuming it's a copy of the lemmy source code, for example, which means it is its own contained version of Lemmy. This instance sets it's rules, creates its own sub communities etc. You join the instance that relates to you the most.

The Fediverse consists out of servers of different social media projects - Lemmy is one of such projects; I'm writing this from my Friendica account. Others are Miskey, Mastodon, Pixelfed, Funkwhale, even Wordpress blogs can be made to be part of the Fediverse with some addons (and I'll stop the listing here, as it really gets long. All the software projects that build together software that runs on the servers/inastances of the Fediverse have one thing in common - they all have implemented a protocol named ActivityPub that lets accounts on each of these different servers exchange interactions.

But yes, basically you pick the one you like and use it.

But does that mean you can only post in that instance?

Yes. You can only start new threads of conversations on your own account on the server that you have chosen. You cannot use your Lemmy account to post some images directly to a Pixelfed server, or write a blog posting to a WriteFreely server from your account on Lemmy. You'd need an account on a WriteFreely instance to write blog postings there.

What you might be able to do (depend on the software you are using) is to reply to a persons posting on some other Fediverse server - like I'm doing right now.

Framasoft has a short introduction video about the Fediverse.