The IS is nothing to do with the image. The lens has sensors in it that detect physical movement, one vertically and one horizontally. These then move one of the internal lens groups to compensate for the small amounts of shake and so keep the image stable.
Mode 2 should be used for panning as it disables the horizontal sensor and so doe not try and fight the movement you are making but will compensate for the shake in the vertical axis.
An easy way to see the IS effect is the focus on a small object close up at full zoom and then watch it hop around in the view finder. Now swithch on the IS and watch it lock-on. Mode 2 will give movement in one axis only.
More information here Canon IS Lens Guide
Jeff
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