To see how the digit-by-digit method works, it might work best by stepping through an example. Let's set $N = 57$, and our aim is to find the sequence of digits $d_0, d_1, \ldots$ such that $\sqrt{N} = \sum_{n = 0}^\infty d_n 10^{-n}$. Notice that for every $n$, we want $d_0.d_1 \ldots d_n \leq \sqrt{N} < d_0.d_1 \ldots (d_n + 1) = d_0.d_1 \ldots d_n + 10^{-n}$.
So to find $d_0$, we're just looking for a number $a$ such that $a^2 \leq N < (a+1)^2$, and it's pretty clear that $a = 7$ works because $7^2 = 49 \leq 57 < 64 = 8^2$.
Then to find $d_1$, we now have $(7 + \frac{d_1}{10})^2 \leq 57 < (7 + \frac{d_1}{10} + \frac{1}{10})^2$. If we subtract $7^2$ from all of that, we get:
$$\begin{eqnarray} (7 + \frac{d_1}{10})^2 - 7^2 & \leq & 57 - 7^2 & < & (7 + \frac{d_1 + 1}{10})^2 - 7^2 \\
49 - 2 \times 7 \times \frac{d_1}{10} + \frac{d_1^2}{10^2} - 49 & \leq & 57 - 49 & < & 49 - 2 \times 7 \times \frac{d_1 + 1}{10} + \frac{(d_1 + 1)^2}{10^2} - 49 \\
\frac{d_1}{10}\left(14 + \frac{d_1}{10}\right) & \leq & 8 & < & \frac{d_1 + 1}{10}\left(14 + \frac{d_1 + 1}{10}\right)
\end{eqnarray}$$
So we're now looking for the biggest value for $d_1$ that keeps that left-hand inequality true, since the right-hand inequality is the same thing but using $d_1 + 1$ instead. With some trial and error we'll find that $d_1 = 5$ is right.
We can keep doing the same thing - once we have our $n$th approximation $a_n = d_0.d_1\ldots d_n$, we want to find the next one using the bound $(a_n + d_{n+1} \times 10^{-n-1})^2 \leq N < (a_n + (d_{n+1} + 1) \times 10^{-n-1})^2$, and that then becomes:
$$\begin{eqnarray} (a_n + d_{n+1} \times 10^{-n-1})^2 & \leq & N & < & (a_n + (d_{n+1} + 1) \times 10^{-n-1})^2 \\
\left(a_n^2 + \frac{d_{n+1}}{10^{n+1}}\left(2 a_n + \frac{d_{n+1}}{10^{n+1}} \right) \right) - a_n^2 & \leq & N - a_n^2 & < & \left(a_n^2 + \frac{d_{n+1} + 1}{10^{n+1}}\left(2 a_n + \frac{d_{n+1} + 1}{10^{n+1}} \right) \right) - a_n^2 \\
\frac{d_{n+1}}{10^{n+1}}\left(2 a_n + \frac{d_{n+1}}{10^{n+1}} \right) & \leq & N - a_n^2 & < & \frac{d_{n+1} + 1}{10^{n+1}}\left(2 a_n + \frac{d_{n+1} + 1}{10^{n+1}} \right) \\
\end{eqnarray}$$
So in other words we look at the gap between $a_n^2$ and $N$, and look for the value of $d_{n+1}$ such that the term on the left comes closest to matching that residual gap without going over. And what you'll find (but I won't prove rigorously here) is that the restriction of $d_n$ to single digits means that you will be able to work to within $(2n)$ decimal places, which is why in the "long division"-like method you pull down two digits at a time.