Most likely, it will not allow you to format an active system partition. What does that mean? It means that if you booted your computer XP, and it was booted from the C:, it will not allow you to format that partition.
A format is a disk operation that completely initializes (blanks / clears / erases) a partition. I say "partition" because you can have more than one partition on a physical hard disk, and a format cannot jump a partition barrier.
Specifically to your question, it would be possible (although unlikely, but I did this as an exercise to teach a young grasshoper that his bag of marbles was missing a few) to have two partitions: a C and a D. You could then put XP on D: and boot from there, and in that particular case, you could format C: and have the operating system remain (because it is on D:)
You're correct, nanosani, but let's clarify it a little perhaps.
If you load Windows XP onto the D: drive, some small files will also be created on the C: drive which run at bootup and instruct where to look for the Windows files. If you format the C: drive afterwards, those small files will be lost, of course, and the system will be unable to boot into Windows.
Booting from the Windows CD and 'repairing' the installation will write those files back to the C: drive, and the situation will easily be corrected.