Sort of. It does block the users, but only on your specific instance. If you’re interacting with a post on another instance and that instance is federated with them, you’ll still see them on that third instance.

Defederating basically takes the three instances from a closed triangle ◺ (where all users can see and post on all three instances) to an open triangle ∟ (where your instance and the defederated instance are blocked from each other, but the third instance can still see and interact with both.)