1: I guess the main thing I need is the proper sketch to load into the Arduino (for the portion I have bolded above). The device initiating the telnet session (through USB) will NOT have any sort of driver, IDE, etc.
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If this works as expected I will probably drop on an xport so I can telnet over my network instead of through USB. This basic ethernet to serial "proxy" should do the trick: http://trac.mlalonde.net/cral/browser/branches/follower/libw5100/src/demo/simple_serial_proxy/simple_serial_proxy.pde
My observation is that you may be mixing your terminology somewhat.
By "telnet" do you mean using the actual "telnet" protocol (via the "telnet" program) or do you mean "by typing stuff on a command line"? One cannot "telnet" over USB but it is possible to have a serial connection over USB that enables one to "type stuff" and have that sent over serial to the device.
Also, be aware the ethernet-to-serial proxy you link to (which I wrote) was designed to work on the WIZ810MJ/WIZ811MJ boards, not an xport.
If you can clarify you needs more precisely, we may be able to help you further.
--Phil.