I'm currently running Photoshop CS2 under Vista... it's how I've done most of the artwork on this site. I haven't installed Illustrator, but anybody that says Photoshop won't work is just flat out wrong.
If you have problems installing, you may want to launch the setup in Administrator mode by right-clicking on the setup program and choosing Run as Administrator.
It's true that Vista requires 1GB of RAM, but I've actually gotten it to work with less... it's just slow. I think that the requirement was Microsoft's way of forcing people to upgrade to decent machines to use Vista, so that it will seem very fast.
2GB of RAM should be plenty to do virtually anything you want to do. I have quite literally 20-30 apps open at any given point while running Vista on a 2GB machine, and I have no problems whatsoever. The system will report weird numbers of the amount of memory free, because of SuperFetch, but ignore it and just see if your apps run fine.
Games are still a little shaky on Vista... I've heard a lot of complaints that their favorite game doesn't run on Vista, etc. I'm not an expert on this, because I don't really play games. Too busy working at my multiple jobs =)
Back to the first point... I'm guessing there's a problem with the compatibility of your CD drive with XP. There might be an option in the bios to put the cdrom drive into some sort of compatibility mode, which would allow booting.