I know if you cancel your activation/service, you can still use your iPhone, but as for upgrading, never heard of anyone doing it. If I recall, when doing an upgrade or a restore, my iPhone looks to activate before it starts, so you might be SOL.
This is a very good point. I for one and many others maybe) will be giving my old iPhone to my 9 yr old, to use as an ipod when the V2 comes out. I would think that when you dock it iTunes would know that it is deactivated, still load and play music and video etc. So why not updates as well. Of course you would have the problem without a sim reading as unLocked.