I don't think you can install into FAT32
You'll probably run into problems because FAT32 isn't case sensitive, and neither does it support file permissions. When running Linux, it'll certainly be possible to mount your FAT32 and NTFS partitions (NTFS is currently read-only), though unfortunately, Windows itself doesn't yet come with built-in ext 3 or ReiserFS support. Maybe there's some 3rd party add-on which will do the trick.
I suggest partitioning the drive like this:
hda1 NTFS (your current XP install)
hda2 (linux swapfile)
hda3 / (ext3 or Reiser)
A /boot partition would also be nice, but it looked to me like the Knoppix installer only expects to see 2 partitions?
2 gigabytes is the bare minimum that Knoppix needs for a hard drive install (there's a lot on that compressed disk). I don't recall having to add on a C compiler afterwards-pretty sure it's already there.
Once installed on your hard drive, Knoppix is a somewhat customized Debian Linux, with a lot of packages from Debian's testing/unstable tree. So yes, adding/removing/configuring software to your heart's content is pretty easy. As far as having part of your operating system reside on CD, probably no, not in the way I think you mean. Technically probably do-able, but who's going to go through the fuss when hard drives are so cheap these days ;-)