Windows Server blog by Kurt Roggen [BE]

Volume Activation (VA) 2.0 is designed to automate and manage the activation process while addressing the piracy and product key management problems associated with Volume License Keys (VLKs) issued for Windows XP and Windows Server 2003.  Volume Activation 2.0 eliminates the use of product keys at installation and enables better protection and management of customer-specific product keys through some new and enhanced activation management tools.
All installations of Windows Vista and Windows Server 2008 must be activated.

Multiple activation options exist for volume customers: MAK independent, MAK proxy and KMS.
Let's have a closer look at KMS... 

The Key Management Server (KMS) is used to establish a local activation service (Key Management Service) that is hosted locally/internally in your environment.
Use of the KMS eliminates any need for individual machines to connect to Microsoft to activate. 

A KMS key is used to enable/activate the Key Management Service on a KMS server/host machine.  A KMS server/host can run natively on Windows Vista, Windows Server 2008 and even Windows Server Core 2008.  Computers running volume license editions of Windows Vista and Windows Server 2008 are KMS clients and try to locate the KMS server/host using one of the two methods:

1. Auto-Discovery: the KMS client uses Domain Name Service (DNS) records to automatically locate a local KMS host (DNS RR - Resource Record).
2. Direct connection: the administrator specifies the KMS host location and communication port (default port is 1688, but configurable).

Windows Server 2008 KMS clients require a KMS activation threshold (n-count) of only 5 physical machines to activate. Windows Vista clients require a KMS activation threshold of 25 physical machines.  A single KMS server/host can support and activate unlimited KMS clients. A KMS client must connect with KMS host anonymously at least once every six months (180 days). 

The current Windows Server 2003 based KMS (Key Management) activation infrastructure requires an update to support Windows Server 2008 systems and Virtualization.
This update will be released at Windows Server 2008 launch timeframe. 

Windows Server 2008 systems

Virtualization

Both KMS server/host and KMS client will support running inside virtual machines. 
The KMS server/host can now run on a Windows Vista-based virtual machine or a Windows Server 2008-based virtual machine. So you can start considering to put the KMS server/host on a virtual machine.  The KMS clients (read: all Windows Vista clients and Windows Server 2008 installations) running in virtual machines can now also be activated through the KMS server/host.  However, only physical computers are added to the KMS count.

One final remark!! KMS and MAK keys apply to product groups rather than being edition-specific. This greatly simplifies key management by reducing the number of possible keys.
KMS keys are hierarchical by Volume Product Group: a KMS key can activate systems with any of the Windows editions in its corresponding product group as well as Windows editions listed in lower product groups, as the table below illustrates.

For more information:

• Volume Activation 2.0 on Technet
• Volume Activation 2.0 Technical white papers (Overview, Planning Guide, Deployment Guide, Operations Guide)