I'm experiencing the same problem here.
As for the "USB Video Device" vs "Built-in iSight" thing, if you go into the Device Manager and poke through the device IDs and whatnot for the Built-In iSight device, it says somewhere (don't remember exactly, there were a lot of items) that it's a "USB Video Device" for the driver.
I found a report of the same thing happening with Marratech video conferencing, so it's not a MSN/WLM issue, in my opinion. The problem in Marratech can be rectified by deleting the data file that holds the settings for the camera when you click the "advanced" button and get that ugly Windows Driver Model generic webcam adjustment page.
However, MSN/WLM stores its data in a central repository, the registry, and therefore cannot be deleted easily. I can't find WLM's registry entries for webcam settings so far.
At any rate, I think it's a driver problem (on Apple's side) due to the Windows webcam dialogue incorrectly picking default values, then storing "incorrect" ones in the registry, after assuming they're the correct defaults. I noticed this when opening this properties box in VIDCAP32.EXE - many of the sliders were in the wrong spots for their current settings, and some of the sliders were beyond their normal maximum ranges.
I'll post back if I can get anything fixed here. Hopefully it'll just go away in Leopard's boot camp *crosses fingers*