Though you can choose whether to be Prepared or Unprepared, the environment decides whether you are In-Combat or Out-of-Combat. By default you are Out-of- Combat during Unprepared State. Whenever you or one of your nearby Party Members performs a hostile action or aids another Player Character In-Combat, you will turn In-Combat and the outline of the Combat Indicator will turn red.
When you are In-Combat you will not be able to make any changes to your Player Character that would affect your statistics or your Player Character appearance (excluding Skill-effects). This means you cannot change Equipment, Skills, Sigils and Bodyslots. More importantly, while In-Combat your Health Points will regenerate at a slower rate and you will not be able to use Sit (X).
You will remain In-Combat as long as you remain near adversaries, In-Combat Party Members or active during combat. To return to Out-of-Combat, you will need to enter Unprepared State and refrain from entering or remaining near areas of combat for a certain period of time. Doing so will cause the red outline of the Combat Indicator to disappear and set you back to Out-of-Combat.
While Out-of-Combat, you have access to all your Interface options again, your Health Points regenerate at a faster rate and you are once again allowed to Sit (X) to boost Health Point regeneration even more.