I guess your problem did not dissapear til now... ?
Some ideas I got while reading the whole thread:
- Second harddrive is for temp. storage, avi files and swap, right?
I guess it's formatted with FAT32 filesystem? The FAT32 really gets
crapped when files get larger than 1,8 GB. (Yes, the M$ knowledgebase
tells something else, but I've seen a lot of problems with FAT32 and
1,x GB files.)
The swap file should not be in use as you have 1GB of ram.
There are loads of registry tweaks for systems running 1 GB and Win9x.
I had to tell my Win9x only to use 768 MB. No chance booting with 1GB
enabled. (The problme really depends on system. My friend's running Win9x with 1,5 GB RAM absolutely stable.

There are also tweaks for Win2K running the full 1GB. First I'd tell the
system NOT to swap kernel stuff out (Sorry, don't know the registry hack
right now

there's no more space in physical RAM.
(Search for ConservativSwapFileUsage on google.)
Setting this will make sure that swap is used only when needed.
- Next I'd boot a knoppixCD and probe the IDE HDDs.
I guess you already did this using the manufacturers' HDD tools.
I don't rely on these tools completely as they do NOT use the harddrive
usual duty does.
- Last thing I'd try is booting a SuSE Linux install CD. (Could be any Linux
I guess, but I'm very familiar with SuSE Linux and know where to find the
stuff needed

A whole run will take ages but really probes the RAM. (Maybe one will
think that damaged RAM will not cause HDD LED to be ON all time, but
damaged RAM can cause ANY problem...

If all the above runs fine I'd think of Windows beeing the source for
problems - not the hardware.
Hope this helps you a bit,
Atropos