Iphone just for development (no service)?

Is it possible to buy an iphone without service, and then use that iphone for development?
Will an iphone without service still work with XCode to test apps?
Can you still update iphone OS (without service) when new OS versions are released?
Will an iphone without service still function like an ipod touch (everything works except phone stuff)?
What's the best way to buy an iphone without service? Should i just buy via AT&T and pay cancellation fee?

If you buy a first-generation iPhone used, you can connect it to your computer, provision it for development, and install the provisioning profile through Xcode. That will add a "Dismiss" button to all the "waiting for activation" dialogs so you effectively don't need to activate the phone. I did this with 2.0 for a few weeks, and there were a couple gotchas (make sure you don't leave airplane mode on when you upgrade the firmware!) but it worked pretty well overall. I ended up getting service for the phone before 2.1 came out, but I'm not aware of that having changed.
However, I've seen warnings in the development portal that this won't work with OS 2.2. I don't know if this is just during the beta or if the final version will behave this way too. There does seem to be a workaround right now, but they might close that loophole.
Do note that if you're in the U.S., you can get an original iPhone data plan if you're activating an EDGE iPhone. This will cost $10/month less than an iPhone 3G plan. If you talk with AT&T you might be able to make other arrangements (I think there's an even cheaper plan available for the deaf that doesn't include voice calls), but I don't know the details of any of that, nor do I know what may be available in other countries.
Honestly, though, your best bet if you're an individual developer might be to get a family plan and put both your regular phone and your development iPhone on it. One thing you'll need to test is how your app behaves when it's used during a phone call, and the only way to do that is to have an iPhone with phone service. Similarly, you'll need to test how usable your app is when it has little bandwidth or a poor connection or just in direct sunlight at midday, and having EDGE access will help you with that. If your product is even marginally successful, the service will pay for itself.

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