Let us look at the derivation detail. I will try to note, all assumptions/approximations made. I hope I don't miss any. The basic model is as follows: First an enzyme substrate complex is formed. The substrate can either be released unchanged, or undergoes modification to form the product. This can be captured in the following two equations
$$\ce{E + S <=>[k_a][k'_{a}] ES } \tag{1}$$
$$\ce{ES ->[k_b] P } \tag{2}$$
First, assumption herein is that initially, so little product is formed that the reverse reaction (product combining with enzyme and re-forming substrate) can be ignored, and hence the unidirectional arrow.
Rate of formation of product is, $v = k_b \ce{[ES]}$
And we use the steady-state approximation to write,
$$\frac{\mathrm{d}\ce{[ES]}}{\mathrm{d}t} = k_a\ce{[E][S]}-k'_a\ce{[ES]}-k_b\ce{[ES]} \approx 0$$
Re-arranging, $$ [ES] = \overbrace{\frac{k_a}{k'_a + k_b}}^{K_M}[E][S]$$
Now, let us re-cast this in terms of concentrations of enzymes, and substrate we started with.
From the explanations given in different sources, I think this assumption is used in expressing the total enzyme concentration as the sum of free enzyme and enzyme-substrate complex. Is my understanding correct?
$$\ce{[E]_0 = [E] + [ES]}$$
No. The equation given above holds regardless of the initial substrate concentration.
Substituting for $\ce{[ES]}$
$$\ce{[E]_0 = [E] + \frac{K_M [ES]}{[S]} = [ES]\left( 1+ \frac{K_M}{[S]}\right)}$$
In which step of the derivation of the Michaelis-Menten rate law is this assumption used?
Now, finally, the substrate concentration is so large, that $\ce{[S] \approx [S]_0}$
This, finally gives us
$$\ce{[ES] = \frac{[E]_0}{1+ K_M/[S]_0}} \tag{*}$$
Plugging this in the expression for $v$, we get the Michaelis-Menten equation
$$v = \frac{k_b\ce{[E]_0}}{1+ K_M/\ce{[S]_0}}$$
What happens when the enzyme concentration is in the same range as that of substrate concentration? Why is it important to make this assumption?
You don't get a nice expression for $\ce{[ES]}$ like equation $(*)$ which only involves constants on the right hand side.
$$\ce{[ES] = \frac{[E]_0}{1+ K_M/([S]_0-[ES])}} \tag{**}$$