1) You can change the amount of disk space allocated.
2) Nasties do not 'hide' in it. But if a nasty is in a system folder like c:\windows\system32 then it will be copied into the restore point. This cannot do any harm unless you restore to that point. It is always better to have a restore point to go back to (even if infected) than no restore point at all.
3) If you are backing up using a program like Norton Ghost where you can restore an earlier image by booting from the Ghost CD then you probably don't need to worry about system restore.