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What are the rules for Lantern of Revealing?
Does this item have to be outside of the character?
A player of mine says he can keep this in his backpack, covered and protected, and have it still work.
I do't think it works this way.
Does the character have to hold it? He wields a two-handed weapon, so I don't think he can hold it and and swing his weapon.
I do believe he can activate it and set it down, though.

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Because the effect is based off the light (hence the range of effect) falling upon an area, would not work well in a pack. The item says it "operates" like a lantern with one additional effect that (while lit) it reveals hidden things. Much like a sword in a scabbard isn't going to cause much damage, same with the lantern. Must be used.
He could set it down.
No reason the light wouldn't shine bright enough even if hung at side to cause it not to work.

Claxon |

Aura faint evocation; CL 5th
Slot —; Price 30,000 gp; Weight 2 lbs.
DescriptionThis lantern operates as a normal hooded lantern. While it is lit, it also reveals all invisible creatures and objects within 25 feet of it, just like the spell invisibility purge.
I would say in order for it to work it has to be lit, and it has to let the light out to purge invisibility. So, no it doesn't work in his pack covered up by everything. In fact, if he tried it I would say his backpack catches on fire.
He can light it and set it down though, and that would work just fine.

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That's what I would think.
What are the restrictions if this is hung from a belt or something during battle? Would it cover 360 around? Any penalties apply for having a lantern hanging like this?
360?? I'd say no.
But there is a Lantern Shield, where you can hook a lantern into it.

Claxon |

There is for instance a bullseye lantern which only sheds light in a cone, so it does provide a precedent to restrict the arc of lighting.
However, there is also something to the idea that there is no "facing" in Pathfinder either. The rules don't really provide any "illumination" on the subject and how to handle what would provide a real world obstruction to lighting.
After consideration it is probably better overall for the game if you just let the illumination work normally (whether held in hand, attached to a belt or a shield).