Which to use as system drive?

System Specs:
ASRock P55 Extreme
I5-760
4GB DDR3 1333 Memory
GTX-470
WD20EARS - 2TB
WD3200YS - 320GB

I've been running this setup for a little over a year with the WD20EARS partitioned with the C with 175GB for Windows 7 Ultimate system and 1.64TB for data storage, I just got the WD3200YS today and from what I've been reading people seem to be saying that the WD20EARS arent good for Windows Home Server system but does the same apply to Windows 7?

So should i format the C Drive partition on the WD20EARS, format the WD3200YS and install Windows 7 onto the WD3200YS to get better speeds or just leave the current setup?

Using HD Tune

Benchmark WD20EARS

Minimum - 2.6 Mbs
Maximum - 124.3 Mbs
Average - 83.6Mbs
Burst Rate - 140.3Mbs
Access Time - 17.8Ms

Benchmark WD3200YS

Minimum - 36.8 Mbs
Maximum - 63.6 Mbs
Average - 54.5Mbs
Burst Rate - 133.4Mbs
Access Time - 13.7Ms

I would use the WD3200YS as your system drive - it should improve system speed mainly because you will reduce current conflict in seek time having both system and data partitions on the same physical drive.

I suggest the same, you can always use the one drive for windows itself and the other as storage.
I have a very similar setup myself, one drive is devoted mainly to my OS's (both Windows and Linux) and the other is devoted to personal space