Xbox is based on a Pentium III processor, while Xbox 360 is based on a custom triple-core PowerPC processor co-developed with IBM. This is but one of many differences between the platforms, but one people are familiar with. Digging deeper, you would find that nearly everything has changed. Graphics, audio, networking, etc. have all been replaced with different subsystems.

Xbox games all run on the assumption they are being run on the exact set of original hardware. Changing anything usually means breaking some kind of behavior games depend upon. Therefore, Xbox 360's backwards compatibility had to emulate the exact configuration of an original Xbox.

One way to do this is embed the parts of an original Xbox into an Xbox 360. This was the path Sony chose to use in PlayStation 2's compatibility. However, Microsoft doesn't own the intellectual property in Xbox: it's owned by various other companies including Intel. Microsoft wouldn't have the freedom to take the parts needed for compatibility, shrink them down, and put them inside Xbox 360. And no one would want a bigger power supply any way :)

Another option is software emulation. Many of you already know this is the path Microsoft has chosen. Our software emulator works much like emulators for other platforms like SNES and Genesis. However, one key difference to keep in mind is that the Xbox emulator is emulating the immediate previous generation of games. Most emulators come out many years after a console has launched and run on PCs that represent quantum leaps in performance.

News-Source: Xbox Dev Team Blog Site