Observe Combat. I believe this is the system that makes them see combat and possibly join in, or go "This fight 'oughta be good!", or "I'm getting the heck outta here!"
You would check it if you want combat to completely halt the scene and for everyone to act normally (i.e. it's a peaceful scene and if bandits run up by chance you want people to react normally).
However if your scene has scripted combat you would uncheck this so people don't react 'normally' where they shouldn't.