XP has two stages of authentication.
First, you need a valid product-key, which will be on a yellow sticker with the installation CD. Without this, you cannot even complete the installation of Windows XP.
After you have installed, there is a second authentication phase which must be completed within 16days I think? I can't remember, it gave me something like 15 days, and then the next day refused to boot. This phase involves your PC connects to one of Microsoft's authentication servers (at the end of a toll free line) and authenticates itsself. If you can't dial in (no connection) you can do it over the phone, you get a huge number you key in on tone dial phones, and the phone reads back a number you enter. If this fails, you will be sent to a representitive on the phone.
Windows keeps a track of hardware, and if you change it too much, you must re activate, diff PCs, diff hardware, and so they can track if it has been illegally installed elsewhere. I wouldn't go as far as to say Microsoft are looking at other software, nor do they know who you are, its a fully anonymous service.
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