In this sentence "quello/a/i/e" is a pronoun (used only without a noun) meaning "that one/those ones". When used as an adjective (only before a noun phrase) it behaves just like the definite articles: quel/quello/quell'/quella/quei/quegli/quelle. So if an adjective was required in this sentence (before a "pure" consonant as in "nero"), it would have been quel:
- Preferisco quel nero (adjective + noun) = I prefer that black
- Preferisco quello nero (pronoun + adjective) = I prefer that black one
Thus, even if "I prefer that black" is grammatically correct, it is not a correct translation of "Preferisco quello nero".
Quello is the full form of the word, but it changes like the definite article according to the noun that follows it (see http://italian.about.com/library/fare/blfare112a.htm for some examples). So, if quello modifies a noun that starts with a consonant other than an impure s or z, it changes to quel (i.e. "quel ragazzo").
Since quello precedes a noun that starts with st, z, etc (like "lo" does), I was surprised too that this phrase uses quello and not quel. But I did a Google search for this sentence and found plenty of examples. My best guess (and I'm not an expert at all) is that in this sentence quello isn't modifying nero, because nero isn't a noun. Really, quello translates to "that one" rather than "that" when it stands all by itself and doesn't modify anything, so it just remains in its full form. That's my best guess, anyway.