Mon,

>So it is possible to have a single Win 2K, XP Pro, or 2003 web server running both the web app using .NET and SQL server? Why is it preferrable to have a separate computer for the SQL server?

It is possible to run both applications on one server; however, there a few reasons I would choose not to.
A) From a security standpoint, it is better to have you SQL box behind the Firewall and you Web Server public (the less boxes exposed to the world, the better)
B) SQL Server (if to run optimally) needs A LOT of RAM... From my understanding, the more - the better
C) Allow for growth... It's a bit easier to Beef up you SQL box (if you find that's where you're having problems) than to later have to decide to throw a new server in the mix.

A lot of things must be taken into consideration... If just doing a beginner app or personal stuff, I'd get setup however I could. But if planning for clients, I would definitely reccomend a dual server setup.

>We'd want to make it as easy as possible for the end user, so we won't use Windwos Forms. I would guess though that Microsoft would include the 20 MB .NET engine in its next OS, which would make it easier for end users (unless of course they are not using Windows, but that would be their own fault :) )

Very true : ) I bet we'd both be surprised how slow the OS upgrade path is for some companies...

>Yes it would be helpful to see example hosts for .NET and SQL server. This will help me decide whether to go with shared hosting, dedicated hosting, or even hosting it ourselves!

As Nancy reccomended
http://www.webhost4life.com
Pros: Very featur rich, SQL Server, Unlimited Traffic, etc...
Cons: Sometimes slow due to the number of people, per server...

http://www.orcsweb.com

Also, www.ASP.net keeps an ongoing list...
http://www.asp.net/Hosters/Default.aspx?tabindex=8&tabid=1

Hope that helps : )