Paul Thurott over at his SuperSite for Windows has more information on how this works:
This would be great news for those that have been sticking onto XP due to fears that their software may not be compatible with Vista or 7. More screenshots of it in action can be found here: http://www.winsupersite.com/win7/xp_mode_pre_shots.aspXP 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.
Obviously, XPM has huge ramifications for Windows going forward. By removing the onus of legacy application compatibility from the OS, Microsoft can strip away deadwood technology from future versions of Windows at a speedier clip, because customers who need to run older applications can simply do so with XPM. For Windows 7 specifically, XPM is a huge convenience, especially for Microsoft's corporate customers, who can of course control XPM behavior via standard Microsoft administration and management technologies like Active Directory (AD) and Group Policy (GP). And it significantly recasts the Windows 7 compatibility picture. Before, Microsoft could claim that Windows 7 would be at least as compatible as Windows Vista. Now, they can claim almost complete Windows XP compatibility, or almost 100 percent compatibility with all currently running Windows applications.
Source: Paul Thurott's Super Site for Windows - Secret No More: Revealing Windows XP Mode for Windows 7
Let's face it, as great as Windows XP was, it's an old operating system, and is nearly eight years old (launched in Fall 2001). It just recently entered its Extended Support phase, which means that only security updates will be provided for XP unti April 2014; no more major updates like Service Packs will be provided.
While some may have had reason to prefer XP over Vista due to early driver issues (which have all been resolved BTW, by updating system drivers to the latest ones) and unwarranted worries, Windows 7 has already proven to run faster than Windows XP and Vista, given the benchmarks released by ZDnet and various users that have tested beta versions of Windows 7.