Yes, it's possible to simulate Arduino code using ISIS.
Here's a very simple tutorial I found: http://www.youspice.com/ys/gettingstartedwithproteus.3sp
I've not tried out any really complex sketches yet. But I guess it should work like a charm.
When you click on upload, the hex file is created in the Temp folder by the Arduino IDE. To find the hex file in Windows XP, goto to this location: C:\Documents and Settings\<user-name>\Local Settings\
and just search for *.hex. Make sure you select "Search hidden files and folders" check box.
Here's an old forum thread discussing the same:http://www.arduino.cc/cgi-bin/yabb2/YaBB.pl?num=1280494997
Hope this helps!