Have a look at http://support.apple.com/kb/ht1364 which should tell you all you need to know. I suspect, given the all-round flakiness of iTunes, that the whole thing will crash and burn if the external drive is ever absent at boot, so you might want to bear that in mind and consider fitting a second physical hard disk to your machine if you can't face the joys of doing a complete reinstall on a bigger primary drive.

I run my iTunes library on a separate partition on the same physical hard drive and it seems to cope with that alright, but does still maintain a small (under 10 Mb) folder under the My Music directory (I'm now on W7, but only upgraded recently and IIRC, XP behaved similarly).

iTunes is a hideous piece of bloated counter-intuitive hammered-together the-Heath-Robinson-estate-would-sue-if-I-called-it-Heath-Robinson software, which is such a *huge* pity because the iPods themselves are absolutely fabulous bits of kit. If only iPods would accept management from Windows Media Player or Winamp ...