It's a joke. And not a very funny one. It is saying "if you took a sentence out of context, it sounds dirty." When you hear someone say "that's what she said," you need to think back to the sentence that came _right before it_. Then you need to imagine that a woman is saying that sentence to a man while they are intimately involved. (Depending on the sentence and the audience, you may also be implying that *you* are the man who is being told the sentence or that your friend is the man who is hearing the sentence. That way, it could be a good-natured, kind of funny insult.)

It's used to imply someone is not saying what they really mean 'that's what she SAID but what she MEANT was...' Of course it can also just be someone explaining what someone else said in case you didn't understand/hear. Or someone pointing out that someone else said the same thing 'that's what SHE said' - she said that too.

It's an innuendo that you use when you want to say you are successful with women, but i'm a non-native(nor am I successful) so I can't really explain it here's a good video that explains it https://www.youtube.com/watch?v=PFWPiKy9HQ0