Is it worth replacing an 896MB GTX 260 with a 2GB 560?I have 8GB RAM but when running XP, it sees only 3.5GB. I believe also that XP uses some RAM to support GPU operations, is this so?

It is installed and seems to be working fine.

You need to install a 64bit operating system, otherwise it's a total waste of all that extra memory. Yes, once all a video cards VRAM has been used up it will turn to system memory, but this is not a good idea as DDR2/DDR3 isn't anywhere near fast enough to act as video RAM so you'll get severe performance problems when this happens. Also under a 32bit OS the system can only address 3.5GB TOTAL memory, almost all of which will be getting used to run FS and the OS, meaning there would be none left for the video card to turn to anyway. 2GB VRAM will be more than sufficient for FSX and heavy addons unless you are running a massive resolution.While it will rune "fine", you are still sitting with 4.5GB of RAM that will never be getting used unless you change to 64bit OS.