Well, now we're getting into the dainbramaged microsoft goo. In theory, higher resolution should always be better, but that assumes the software is smart enough to scale everything correctly, and the microsofties aren't that smart yet (they're supposed to get there with longhorn).
It sounds like you may have your DPI setting to something other than the standard 96. Images will look blocky, dialog boxes will be off, etc. Until they fix the way their scaling works, all you can do is set things back to 96 DPI and squint (or buy a 17" laptop, where 1920x1200 looks much more comfortable -- assuming yours is 15").
Right click desktop. Properties. Settings. Advanced. DPI.
You can also play with some of the settings under Appearance, such as title font size. And get the ClearType tuner from Microsoft (one of their PowerToys) to get your fonts looking their best.