Some people seem to be incapable of explaining stuff in clear concise English.
OK here goes - hopefully it's good even from a Non Native speaker.
1) Your application say will only run in XP. So if you want to do this you would normally have to run it on a separate computer running XP or run XP on your current Windows W7 machine by Dual booting - at boot time you can select W7 or XP.
2) This tends to be a real pain in a lot of cases so a mechanism of actually running a version of Windows XP (or another OS) as an appliction on your main OS (W7) has been developed. This is known as running a "Virtual Machine". A piece of software like Virtual BOX, VirtuapPC or VMWARE creates a "hypothetical" computer with typically very common "virtual devices" such as a soundblaster card, a vga graphics adapter, a standard Pentium IV CPU, a Virtual network adapter, it's own "Virtual Disks" etc etc.
3) The choice of "Virtual Hardware" is such that this "Virtual Computer" will work on most normal "Real" computers". The Virtual Machine software also creates a "Virtual Bios" so that when the actual Windows XP operating system is installed it will just see what it thinks is a REAL computer . When the OS makes BIOS calls it will be adressing the Virtual BIOS and not the BIOS of the actual W7 machine.
REAL to "Virtual" devices are mapped by the Virtual machine software so that the XP machine can have its own DVD drive(s), USB connections etc.
4) The Windows XP OS is installed in the usual way just like you would install the OS on a REAL machine -- the only difference is that you first START the Virtual Machine application on the main machine (HOST).
5) Once the XP system is booted up you install applications on it just like you do in a Real machine.
Now this is where the XP compatability mode comes in.
1) With the scenario outlined above there is very little connection between the XP machine and the W7 machine it's running on. You have to build the OS from scratch and set up the Virtual Machine configurations, and any connection between the REAL and VIRTUAL machines can only be done by Networking.
2) XP compatability mode takes a "Pre-built" XP machine which is much more integrated with the desktop W7 machine.
For instance the Host (i.e the W7 machine) disk drives are available with Windows explorer from within the virtual machine without the need for networking etc.
3) Applications installed on the XP machine are available on the W7 desktop -- no need to "Power on" the XP machine etc.
By using a standard "pre built" XP system integrated with the desktop its very much easier for small to medium businesses to gradually manage their transition to W7 both from a hardware AND software perspective without having to use a lot of extra expensive IT resources.
XP compatability mode isn't really suitable for people who need to use Virtual machines for testing different OS'es / software configuratione etc etc. Fully Stand Alone VM software is more appropriate in that case.
Incidentally whatever method you use an XP license is still required for each "Virtual machine" -- but of course while in Beta the XP image can be downloaded for free.
However having played around with this I tend to think a better solution for businesses would be to create a Virtual Server and then just allow the workstation users to log on to it either via RDP or just deploy a "Desktop image".
Still the idea was good even if a little late in the day.