Hi pookie. I'm sure other forum members with more specific knowledge of Windows XP will offer advice, but there is good general information on hard drive replacement on this site click here. This site uses Norton Ghost as the disk cloning software, but there are several others available click here.
To answer some of your questions:
You can transfer all the contents of your existing drive to your new one, but you must first make sure the new drive is formatted in the same way as the old one (I think in your case this is NTFS - but hopefully a XP savvy member will confirm this). You can also load XP on to the new drive, but this would require revalidating your license registration. Windows XP allows some changes to be made to your system without revalidation, but I don't know if this includes changing the hard drive it is installed on. I understand that revalidation is quite simple.
Your BIOS almost certainly requires Windows XP to be on the C drive. The only alternative would be to have dual booting software to redirect the boot process.
You can use the old drive for backing up, or for your saved files. You can delete the program folders from it, and just leave your saved files, or you can leave it as it is but set to be the slave drive. If you do this, your computer will still boot and run programs from the new drive in the C position, but all the old files will be accessible if you need them (the programs, however, won't be run from the old drive).
I have often fitted new hard drives, but always with Windows 98 (both versions), and have allways reloaded Windows from scratch. It has usually been a fairly painless process.