Right, remember my whittering on about thinking for one's self? Readers may dissagree strongly with the following suggestions but if so how did you come by your point of view? Heard thinking..? The following advice is the result of much testing.

Operating System:

Linux... After years of fiddling about I've come to an important conclusion - It's rubbish and I won't waste any more of my time on it. I know, you're so much cooler than me and I bow down before your superior geekability. For all it's supposed issues I'll stick with Windows.
But which Windows?
A tricky question. XP is a good OS. Yes I'll say it again; XP is a good OS. Win7 also seems good so far, which is a pleasent surprise given the disaster that was Vista. For this project I'll stick with XP as I have more experience tweaking it for low resource systems. Regrettably M$ don't see XPe as a consumer OS.
MacOS... Though a 'Hackintosh' is doable, in my opinion it would be too much hassle for this HTPC.

XP it is...

I've yet to come to a solid conclusion regarding M$'s thinking when it came to saddling their flagship OS with so much 'value-added' baggage. One must also remember the OS was written when a P90 + 64Mb of RAM was a good system. Appreciating these points in the context of newer hardware is the key to making this OS fly.

Lighten the Load:

You really can do a lot to reduce the OS footprint for your HTPC - No this won't make the computer 'magically faster' but consider this:

-A fully functioing XP in less than 200Mb means more space for the user and a faster start up as there's less to load.
-The lower memory footprint and fewer running tasks for the OS to manage mean more user time and so snappier response.
-Disabaling services you don't need will also reduce overheads. Maybe 80% can be removed.
-Control Panel->Add or Remove Programs->Windows Components. Be ruthless, all but: Internet Explorer, Root Certificates, and WMP can go.
-A surprising amount of unnecessary stuff loaded as part of the boot sequence can also be trimmed.

I would strongly reccomend the following:
-nLite: To roll your own lightened XP.
-My disabled services list. It will auto-install if you're daft enough to double-click the file.
-CCleaner: Tools->Startup will allow you to disable proggies you don't need.

Press CTRL+ALT+DELETE to bring up your Task Manager and click the Processes Tab. My T5720's fully functional XP with Themes, Anti-Virus, Media software, and a virtual DVD drive says 'Processes: 22'. What does your's say?

Change the Setup:

Having put XP on a diet we need to consider how changing it's behavior may improve responsiveness.

Window's laggy interface even on a powerful system does tick me off. The main cause is the OS will always swap large portions of code to HDD if it can. Anything not recently used is moved out of memory and must be loaded back when needed. This did make sense when computer menory was too small to fit everything. There's no point in trying to turn paging off, XP will page anyway as part of routine memory management.
The only way to remove slow HDD I/O is to put the page file in memory by using a RAM disc!. Yes, it's a waste of memory but the swap file can be as small as 16Mb for XP or 32Mb for Win7. With enough main memory to contain the OS and any running software large chunks of code won't be moved to a small swap file.
A USB 2.0 Flash drive would serve but with limited writes may die after a few months of such abuse.

XP also uses the HDD for temporary files, so moving the TEMP and TMP folders to your RAM disc will help. Once all of that is done moving on to more traditional tweaks will give further benefits.

I would strongly recommend the following:
-Add a RAM Disc of about 32-128Mb with a swap file arround 16-64Mb and remove the old HDD swap file:
->Start->Settings->Control Panel->System->Advanced->Performance Settings->Advanced->Change...
-Move the 'TEMP' and 'TMP' directories to the RAM Disc.
->Start->Settings->Control Panel->System->Advanced->Enviroment Variables->Edit.
-Alter Cache behavior:
->Start->Settings->Control Panel->System->Advanced->Performance Settings->Advanced->Processor Scheduling->Programs.
->Start->Settings->Control Panel->System->Advanced->Performance Settings->Advanced->Memory Use->System Cache.
->Cacheset is a useful progie for tweaking system cache size.
-System Restore is an all round waste of system resources:
->Start->Settings->Control Panel->System->System Restore->Turn Off.
-HDD Indexing slows drive performance:
->MENU click your HDD->Properties->General->Turn OFF Indexing.
-As does Quota Management:
->MENU click your HDD->Properties->Quota->Turn OFF.
-Drive compression is slow and wasteful of CPU time:
->MENU click your HDD->Properties->General->Un-tick Compress.
-Classic Folders are more effecient:
->Any Folder->Tools->General->Folder Options->Use classic Folders.
-Get rid of the stupid animated dog:
->Any Search Window->Change Preferences->Animated Character->Remove.
-Quality of Service will rob most networks of bandwidth:
->Start->Settings->Network Connections->Your network->Menu->Properties->Remove Quality of Service.
->UPnP can go too unless you're sure you need it.
-Run TuneXP:
->Go through every menu option in turn, probably from right to left.
-Run your favorite tweaking app for final setup:
->I like TuneUp Utilities 2006 as an easy way to fiddle with other stuff.
->M$'s TweakUI is also worth a look and it's free...

There's always more tweaks to find but if that little lot doesn't transform Windows for you I'd be amazed.

Two final tweaks that are well worth the effort but I'd only recommend them after careful research are components of XP Embedded.
-Minilogon: Using this in place of XP's Winogon will dramatically reduce boot time.
-Enhanced Write Filter (ewf): Will greatly cut access to your hard drive, and so improve responsiveness.

Software, at last:

I guess the rest is personal preference but here's a few random thoughts.

-XP Codec Pack (2.5.1 at time of writing) for, well, a good selection of codecs.
-Real Alternative and Quicktime Alternative for these formats without the garbage.
-Your favorite media player. Media Player Classic is nicely light weight.
-VIPRE AntiVirus currently seems the best blend of effectivenes and low resource use. Not free, AVG?
-GB-PVR / nPVR is my current favorite media proggie - low resource use and does most things well.
-VirtualCD (v7) can be useful for, er, virtual CD's / DVD's. Demon Tweeks is free with much lower resource use.
-Emulators, I like emulators...