> does it mean that if newline='\r\n' is specified all single '\n'
> characters are returned inline?
Yes.

Let's take a file with mixed newlines:
>>> io.open("c:/temp/t", "rb").read()
'a\rb\r\nc\nd\n'

rb mode splits only on '\r\n' (I'm on Windows)
>>> io.open("c:/temp/t", "rb").readlines()
['a\rb\r\n', 'c\n', 'd\n']

rU mode splits on every newline, and converts everything to \n
>>> io.open("c:/temp/t", "rU").readlines()
[u'a\n', u'b\n', u'c\n', u'd\n']

newline='' splits like rU, but does not translate newlines:
>>> io.open("c:/temp/t", newline='').readlines()
[u'a\r', u'b\r\n', u'c\n', u'd\n']

newline='\r\n' only splits on the specified string:
>>> io.open("c:/temp/t", newline='\r\n').readlines()
[u'a\rb\r\n', u'c\nd\n']