There are two ways to install an operating system. The first is an upgrade install. This patches each piece of your old operating system to make it work like the new one, while still keeping all of your settings intact, your programs installed, and your documents together. There are two problems with this. First of all, it's extremely difficult for Microsoft to support this because they can't conceivably test every possible configuration. Second, it's unstable- upgrade installs always run slower and crash more than clean installs.
The second type of install is a clean install. It used to really be clean- it would delete everything off your hard drive and then install a copy of Windows. Now, it just moves your files aside. You'll still have to reinstall all your programs and move all your documents back when you're done, but it's a brand new copy of Windows. You'll find your computer running much faster after this. When you've finished installing Windows 7, you'll notice a folder called Windows.old in your C drive. This will contain 3 folders: Program Files (probably can delete. But if you want Pinball, copy that folder out first :) ), Windows (delete it) and Documents and Settings (copy stuff you want to keep out of it before you delete it)
Since you're running XP, you have to do a clean install (actually, they call it a "Custom Install" in the Windows 7 setup). Like I said, it's extremely difficult to support an upgrade install. Since it's so hard, Microsoft ended up only having time to support Vista->7 upgrades and not XP->7 upgrades.