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Both approaches are valid depending on what you're trying to accomplish. It's entirely possible to set up a system running Virtual Server and also have it running something like SQL Server (albeit with a much smaller memory footprint than you might have if it was running in a system where little else was present), and then have the VMs talk to the SQL Server instance on the host. It would also be possible to set up instances of SQL Server within each VM, but if you only needed one instance to be present, it would be best to have it installed somewhere else (i.e., it doesn't even need to be anywhere on that system at all -- it just needs to be somewhere on the network where the VMs can get to it). On the whole, I'd recommend dedicating a whole physical server to running nothing but VMs whenever you can manage it, just so you can throw as much physical memory as possible at the problem.
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