I'm running Win XP Media center edition on my HTPC. Works great for me. Look into MCE Tunes for integrating your iTunes library with Media center. It basically allows MC to see your itunes library. Very handy. Especially because my music is all AAC's....
As for DVD backup, I have plenty of storage (2 320GB Seagates in RAID 0
) so I just do a direct rip of the DVD to my hard drive using DVD Decryptor. I think I'm going to be able to fit about 90 - 100 movies on there so I'm good for a while...If you end up ripping entire DVDs, look into My Movies. It's a program that integrates into media center that lets you watch the ripped dvds in media center. It reads the VIDEO_TS folder and functions just like the DVD is in the drive. You just have to add all your movies to it's database, and it downloads the covers, cast info, plot summary, and other cool stuff. Then when in Media center, you can browse it all. It's really cool
And best of all! It's free!
Oh, and VLC can also play VIDEO_TS folders. You just need to go File > Open Folder
That all being said...because you're space limited, you'll probably want to compress your movies. I don't know anything about this so I'll let someone else make recommendations