Maybe you guys can take the "Linux sucks" discussion to some other thread?
1. What type of Linux would be the most widely compatible and still good on a system from about 8 years ago (specs above)?
Ubuntu is the most beginner friendly one, has the biggest and most friendly user base (i.e. very easy to get help) and comes with comfortable workarounds for problems like proprietary drivers.
Ubuntu switched to a new desktop a few years ago though. The change is not as extreme as the one in Windows 8, but it's driven by the same idea ("same GUI on Desktop and handheld/touch devices") and it might take some time to get used to it.
If Ubuntu's desktop ("Unity") is not your cup of tea, use Linux Mint instead. It's based on Ubuntu, but uses more traditional desktops.
2. For my purposes (gradual immersion), should I create a partition on the 160GB hard drive for Linux, or buy a 32GB or 64GB USB stick and install on that?
Ubuntu (and Linux Mint, IIRC) can be tested using "Live" DVDs/USB sticks. You might want to try that first.
Ubuntu can also be installed in parallel to an existing Windows install, without having to reformat your existing harddisk partitions. There even used to be an option to install Ubuntu into a directory on your Windows partition, that's a killer feature if you just want to "check it out" - not sure if that option is still available.
3. Any tips or good guides on creating a dual boot system?
If Linux is the second OS you install, the install process usually takes care of everything - including stuff like importing Firefox bookmarks from the Windows partition.
5. Any tips on creating a Linux partition on a hard drive WITHOUT having to destroy and re-install the XP partition that already exists there (i.e. Swissknife?)?
Ubuntu does that for you. You should still create backups first, obviously.
7. Are all Linux strains compatible? I don't want to be stuck with a Linux branch that can't run common binaries.
Mostly compatible, but might require some work. If you choose one of the big distributions (again: Ubuntu), you won't encounter Linux software that you can't run. Ubuntu and Mint are compatible (mostly, depending on what versions of what libraries a particular Ubuntu/Mint version is using.).
8. In future, will I always need a Windows XP partition to run my legacy Windows XP applications, or is Wine under Linux good enough now?
Depends on the apps. Wine is quite usable for a lot of stuff, games might need a problem.
Personally, I'd simply install Virtualbox and run WindowsXP under Linux. For safety reasons, make sure it doesn't have net access. Virtualbox can hide the actual Desktop and make the windows of your Win applications behave like windows of native applications (move them around on the desktop etc.)
The things I am going to miss most are the EXCELLENT (truly outstanding) quality of WinVICE and WinUAE emulators on Windows.
VICE on Linux should be as good as WinVICE, FS-UAE is using a different approach than WinUAE (Launcher + Emulator excutable, + "ingame" menus that can be used via Joystick) but is very good already and improving constantly.