In simplest terms, XP Mode is XP Professional running as a virtualized instance in Windows 7.   If you’re not familiar with virtualization, it is essentially running a copy of Windows XP as an app within Windows 7.  XP mode is an optional free download for Windows 7 Ultimate and Professional and  includes a full copy of a licensed, pre-registered XP SP3 with IE6.

Additionally, the guest OS (XP in this case) runs on a virtual hard disk (VHD).  The VHD is actually a large, single file on your physical disk.  To the host system this is a single file, but to the guest OS, this looks like a physical disk.  From the host you can move this file around, back it up, delete it, etc… Keep in mind that if you delete this file, you are essentially deleting your guest operating system.

To get started, you need a virtualization engine such as Microsoft Virtual PC (also free).  Once VPC is installed, you need to download XP Mode (this is a large download since it is a full copy of XP SP3).  The setup is painless. The only info you will need to provide is an admin password for your XP instance. Obviously, you can customize all kinds of settings but the defaults are acceptable for running XP. If needed, you can go back later and adjust memory, disk size, etc.

Once the setup is complete you can do anything within the virtual instance of XP as you would do in any other OS. You can install applications, surf the web, change the wallpaper, etc…

In this image you can clearly see XP with IE6 running within Windows 7

So why would you want to run Windows within Windows? I can think of several scenarios in which you would need to run XP within Win7.

1. Keep in mind that Microsoft’s biggest competition for Windows 7 isn’t Linux or Mac OSX, it is XP itself.  Windows XP is everywhere in corporate America. Applications have been written to run on XP since 2001. Many of these apps will indeed run in Windows 7 but there are many that will not.  In a perfect world, the developers would go back and update the apps and provide free upgrades, but Microsoft realizes this isn’t going to happen. So, in order to hurdle the compatibility barrier, they decided to basically give corporations the ability to run the apps in XP within Windows 7.  Not exactly efficient, but a solution exists.
2. No matter how successful Windows 7 is, there will still be people running XP for years to come. Unfortunately, many of these people still run Internet Explorer 6. Web and app developers need a method to test their sites on this older technology. Instead of keeping an old PC around just to test their site on IE6, they can simply fire up XP Mode with IE6.
3. Since the guest OS is installed on its own virtual disk, you can use the virtual instance as a security sandbox for anything you wouldn’t want to do in your host system.  If something gets hosed, just delete the virtual disk and reinstall XP Mode.

Running XP in a virtualized environment is not new or groundbreaking. So what makes XP Mode different?  For one, you actually get a free licensed copy of XP (most virtualized copies of XP are boot-legged).  Secondly, unlike some virtualization engines, the experience is seamless. You can easily copy/paste between the host and guest systems and there is a single mouse which traverses all instances without synchronization. Next, and really cool, is the ability to add a shortcut to a virtualized application within XP to your Windows 7 start menu.  This is significant because it hides the XP OS and only exposes the application to the user.  This is referred to as publishing an application in XP Mode and is enabled by putting the application in the “All Users” group in the virtualized XP start menu.

In this screenshot, you can see a link to Google Chrome which is installed in the XP virtual instance. Chrome is not installed on Windows 7 in this example.

..and here is Chrome running in XP Mode without XP being visible.  Keep in mind Chrome is really running in a virtualized instance of XP.