You can use a 2.5"->3.5" IDE cable and a 3.5" hard drive in your A1200. You'll also need a 1->2 splitter cable for the floppy power connector since the 3.5" drive needs to be connected to that one.
I've been running my A1200 with a Blizzard 1260 and a 3.5" hard drive on an Amiga Technologies black PSU for quite some time now and it works fine. If you experience crashes or lockups I suggest you try out a beefier PSU - this is where the A500 might come in handy.
The A500 PSU connector is identical to the A1200's and the A500 PSU delivers a lot more bang for the buck (strangely enough, since the A1200, unlike the A500, was _designed_ to carry CPU upgrades and hard drives).
If you have a slimline 3.5" drive, chances are good that you will be able to close the A1200 case. Some people cut open the protective metal sheilding over the MoBo and place the 3.5" drive (wrapped in paper or so) directly on the MoBo to be able to close the case.
Personally, I've been using my A1200 without the case top for several years without problems. Of course you have to be a bit careful with where you put your fingers, common sense is a good guideline here
Some people even have their 3.5" hard drive outside of their closed case. This can be done by running all the cables through the hole for the PCMCIA slot. I've never tried this, but it seems to be working quite good.
