Wubi ended up being a mix of point 2 and 3 of the first blueprint [known as UbuntuSetup, now superseded by a newer blueprint called InstallerForWindows]. A guy called Geza Kovacs actually implemented the first prototype which could loopmount a pre-installed image. I later decided to do a full installation into a loopmounted image as opposed to loopmount a pre-installed image and thus Wubi 7.04 was born.

I met Mark at a breakfast during the UDS summit in Boston. Wubi 7.04 was already out at the time, although it was unofficial. I am not sure if he had actually seen it at work at the time, but he knew about it.
I explained the general concept and asked a few questions about extra functionality he would have wanted to see. He mentioned that simplicity was paramount, and that we should resist the geek temptation to show 20 options to do things. Good news for me, since that required almost no UI change. When Wubi actually came out in the 8.04 cycle, Mark was really enthusiastic about it, he told me that Wubi turned out to be one of the most important features of the release, and he was very pleased that such work actually came from the community. There is a big discussion on whether the open source development model can provide the right incentives to innovate. That, to his eyes, was a clear proof that it can.

Regarding adoption, unfortunately I have no exact numbers to give, since the download link in wubi-installers.org points to ubuntu.com and I have no stats for the main website. Furthermore, many users get wubi from the CD, or external websites, and I cannot measure that. We crossed the 3 million downloads a couple of years ago' (before I started using ubuntu.com directly). I would guess that about 10 million users tried Wubi so far, but it is a wild guess.

As for the bug you mention, yes I am aware of that and there are a few hits in launchpad. But it is one of the issues that I cannot reproduce (and hence easily fix). Typically, in such situations, I have to wait for a good bug report, usually that happens when the user experiencing the issue is also a developer and can pinpoint the problem, or I need to guide a savvy user through the debugging steps, but doing that is a lengthy process.