So what does the word squaw mean? There is a misleading and incorrect (pseudo)etymology
out there claiming that it means "vagina
" (or a more crude variation on that theme). It has become so widespread that it has led to certain states at least attempting if not actually going through with legislation intended to rename towns, areas, and other things with "squaw" in the name.
Where did this idea come from? It appears to have started in 1973 in the book Literature of the American Indian where the writers theorized that it came from the Mohawk word ojiska or ojiskwa, which does mean vagina. Later, in a 1992 appearance on the Oprah show, an activist named Suzan Harjo declared that "The word squaw is an Algonquian Indian word meaning vagina, and that'll give you an idea of what the French and British fur trappers were calling all Indian women, and I hope no one ever uses that term again." (One should note that we already have a difference of opinion.) Publicity like that led to movements among people, including many Native Americans, to have the word removed from place names.
But is that accurate? No. According to Dr. Ives Goddard, Curator and Head of the Division of Ethnology, Department of Anthropology and Linguistic Editor of the Handbook of North American Indians, with the Smithsonian Institution, it was a word borrowed from a Massachusetts Indian word: squa, which means a female or younger woman. It was assimulated into the English language meaning essentially the same thing, though generally specifically meaning an Indian woman. The earliest recorded use of it (as a borrowed word in English) is 1622 and it had become part of the language by 1634.
While the Massachusett (no -s) language spoken by the Indians from which the word derives, is indeed an Algonquian language, the tribe lived over 200 miles away from the Mohawks and had no real contact with them. Additionally, the Mohawk language is part of the Iroquoian family, making the original "theory" invalid despite some coincidental simularity in the second part of the Mohawk word. Since it doesn't derive from that language and the real derivation is known to mean female or young woman, the whole "vagina theory" falls apart as well.
That cleared up, is it offensive? While not a lot suggesting that is found in the literature, it has come to be thought of (and used) as a somewhat demeaning or derogatory term in reference to Native American women and many of them dislike it and can be offended by its use. On the other hand, some have little problem with it (depending on how it is used).
It would seem that, while it isn't a vulgar insult, it can and has been used insultingly. It most certainly is not politically correct and one should use it with discretion, or not at all (probably the best option).
(Submitted as a "thing" because it is the word and its origin that is being discussed)
(Sources: www.straightdope.com and www.urbanlegends.com; both seem to be using Goddard as the main source)