Doesn't this mean it is just an emulator? I am a little confused on the "run natively" if "control is emulated through the host OS"
No, CoLinux implements the linux kernel as a part of the Windows kernel. This allows for executing linux binaries in the Windows' kernel space. This means that some of the features like access on block devices have to be routed through the windows kernel.
I created some root filesystem imgaes based on Knoppix and Kanotix for some german magazines in the last 12 months. They worked pretty well and people liked getting a pre configured environment with apache and all that stuff.
Creating a DSL image for CoLinux won't be a big deal, but I think it makes more sense to create an image for VMware player. This is easier to set up (for the user) and does not crash as often as CoLinux.