I also use a 256MB memory stick. The problem with these is, that you cant use the NSLU to create the partitions.
Instead you have to manually partition the stick.
If you dont have any working linux, any ubuntu live, knoppix or whatever will do. 🙂
having the HDD in ext3 surely is the best option. Of course it renders the HD useless for other windows PCs. There are working ext2 drivers for win32 though.