Backward compatibility has been a boon for Microsoft, but also a thorn in its side when it comes to advancing the OS. Thanks to everyone’s favorite green IT technology, virtualization, not to mention capable multi-core processors and oodles of RAM, it looks like virtualized XP app support will be baked into higher-end versions of Windows 7.
As opposed to other desktop virtualization schemes, running Windows XP apps won’t spawn windows with a guest OS desktop. Instead, they will run alongside native Windows 7 applications and will be just as accessible via shortcuts and start menu entries.
As noted on techETA, there’s an informative post at Paul Thurrott’s SuperSite Blog that explains what’s in store.
XP Mode consists of the Virtual PC-based virtual environment and a fully licensed copy of Windows XP with Service Pack 3 (SP3). It will be made available, for free, to users of Windows 7 Professional, Enterprise, and Ultimate editions via a download from the Microsoft web site. (That is, it will not be included in the box with Windows 7, but is considered an out-of-band update, like Windows Live Essentials.) XPM works much like today’s Virtual PC products, but with one important exception: As with the enterprise-based MED-V (Microsoft Enterprise Desktop Virtualization) product, XPM does not require you to run the virtual environment as a separate Windows desktop. Instead, as you install applications inside the virtual XP environment, they are published to the host (Windows 7) OS as well. (With shortcuts placed in the Start Menu.) That way, users can run Windows XP-based applications (like IE 6) alongside Windows 7 applications under a single desktop.
Source: Paul Thurrott’s SuperSite Blog