The handling of processes and memory is way better in the NT kernel (XP uses NT kernel 5.1, just like win2003), it also has better memory protection, making it almost noncrashable. If you have correct drivers and your hardware setup in bios correctly, your system should be as stable as a rock.
Be aware, Microsoft has alot of IE integrated into the operating system, allowing visits to some websites to attack core parts of the system and potentionally install software on your computer or bluescreen it. A good firewall or antivirus doesn't protect against unknown exploits that gets into your computer through the web, so to be on the safe side you should generally stay away from IE. (Use an alternative like firefox/mozilla or opera)
XP also has services which is small server programs that can be automatically restarted when/if they crash. Services are used for file/print sharing, windows update, antiviruses etc. Some of these services has had security hole, allowing viruses to exploit them and spread just by being connected to the internet. If you intend to install XP you should try to aquire servicepack 2 (sp2) first. A good thing would be to get a version of XP that has SP2 preinstalled, or make one yourself.
If you don't have sp2 installed, you must have a good hardware firewall blocking unrequested inbound traffic, or stay of the internet until you have installed sp2, alternatively a good early startup software firewall (Like Kerio PF). If you go with a software fix you must install them before connecting your computer to the internet. You also need to make sure you stay updated with windowsupdate.
I'm not sure but I think you'll need XP if you intend to use bigger drives (and a service pack), you'll also need it to use the NTFS filesystem properly.
As I said XP is way better for stability, I use windows 2000 myself (NT Kernel 5.0), but that's just me.
I always use WinXP Pro SP2, I just used WinME on VMware last night cause I needed to run a software that doesn't run on 2K/XP (oddly, my system seems to refuse to install 98SE, be it under vmware or real hardware)
Depends on the machine. Older P3's should probably stick with '98 for performance reasons. Hell, if you're on a P-200 or below, stick with '95 for the same reasons. If you have a mid-grade P3 or higher, go XP. If you MUST have support for older games, dual-boot or simulate/emulate the earlier OS or pick up an older machine and install '98 on it (if you look, you can find machines like that for $10).
Generally, you keep the software on the machine in the hardware's era and it works fine. Go beyond that and you roll the dice.