Installed SP3, now getting "Generic Host Process for Win32 Services has encountered a problem" message

My daughter has a laptop, and a non-admin user account on it.

I take it every month or so and log on as administrator to take care
of some basic maintenance.

It was running XP SP2 and AVG 8.

When I logged in, the first updates it asked me to install were the
ones from the 9/14 Windows Update, seven in all.

After the required restart, it pushed SP3 to me (I'd had a problem
related to a corrupted installation file installing this previously).

This installed fine and quickly, and then the computer restarted. No
big deal, I've installed three other SP3s with no issues. Logged in,
still okay.

After a short while, a notice appeared in the system tray saying that
I had 30 days to activate Windows. Now this was weird. When I
purchased and set the computer up a year ago (OEM XP Home), I never
had to activate Windows. When I installed SP3 on three other
machines, no activation was required.

I tried to go through the server and the computer said it couldn't
connect, even though I did have a good internet connection and could
connect to any site on the web. So I called Microsoft, got the
required product key or activation code or whatever it's called, and

The yellow Windows update shield was there again and pushed another
update to me. I forget which one, but it was one that failed from the
first seven downloaded today. That failed again. I restarted my
computer and then the real fun started.

At about the same time, I got a warning "Generic Host Process for
Win32 Services has encountered a problem" and I got an error from AVG
8 Free saying that my license key was invalid.

When I tried to check the status of my Windows Updates, I could launch
Internet Explorer (7), but going to the Windows Update screen would
cause IE7 to crash.

Several restarts, and outright turning the computer off, waiting two
minutes, and starting, did nothing. I'd get the same problems about
Generic Host Process, AVG, and IE7.

I uninstalled AVG (grasping at straws, I know). No go.

Downloaded and ran Stinger and it found a Trojan horse on the computer
and deleted it. Restarted, same problems.

Renamed c:\windows\system32\svchost.exe to be svchostBAD.exe, copied a
known good svchost.exe from another computer to it, restarted, and it
got worse. My quick launch toolbar was gone, I couldn't restore it, I
couldn't access the internet.

Switched the svchost.exe files so the original one was in place,
restarted, and I still had no quick launch bar, no expected program
behavior, no internet.

I finally did a system restore back to how it had been right before
installing SP3 and everything seems up and running again. I can go to
the Windows Update page. The computer is on my home network again and
internet access is restored. But I'm back to SP2, which I can live

So my questions are:

1. Why did I have to activate my Windows SP3 for this, when I'd never
been asked to after installing SP3 on other computers?

2. Why might my host process and AVG have been hosed like they were?

3. How do I, just in case I had a bad SP3 installer, go through
Windows Update to download a new one? If I go to Windows Update, it
tells me that I have an SP3 installation waiting to be installed, and
I'd like to delete that and start fresh.

4. Should I just be happy with the computer as it is? Up to now, I've
religiously kept it updated and I'd hate to not have SP3. Probably
not that big a deal today to not have it, but I'm sure in a year, some
key software will expect me to have it.