What does the option "fleet size" mean?

You have the option between a small, normal, and large fleet size. What does it affect? Does it affect the number of ships you can have altogether or how many you can group together (I'm thinking it's this one but I want to be sure).

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It's the former. The fleet size option applies a multiplier to fleet point gains. Normal is the default, small is .75x and large is 1.25x. So with small, you'll get -25% fleet points overall and with large you'll get +25% overall. This is applied every time you research fleet upgrades, so if you were going to gain 100 FP and you're playing with Large, you'll gain 125 instead.

Hope this makes sense :)