You'll want lots of RAM. 256MB is not enough. 768MB (with a 256Mb VirtualPC) seems to work OK. You aren't going to want to run games on it though (though I haven't tried). Video just isn't that fast, and the virtual video card is an s3 Trio; not suited for 3D games.
On the other points.
You'd need to dual boot to run 98 and XP.
[link|http://arstechnica.com/wankerdesk/01q1/wpa-1.html|Here] is a description of how Activation is supposed to work, but details may have changed since this article was written. I think there is an updated description somewhere on their site.
It isn't supposed to be spyware, but you could call for your activation ID via a payphone if it worries you. I'd be more worried about what it does after its activated and running myself. You might start with turning off the autoinstall part of the autoupdate feature.