There are two different, independent concepts here that get confused often.
When purchasing Windows (or Office), there are two different editions you can buy:
Full license. This is the more expensive SKU. You are always welcome to purchase this SKU and install it on a computer of your choosing.
Upgrade license, for owners of a previous version's full license. If you already have a license of XP or Vista, you are allowed to purchase the Upgrade SKU for Windows 7.
Which license you choose is 100% a legal issue; there is no difference in functionality between the two editions. The idea is that you purchase one full license of the software and from then on you can upgrade to newer versions at a reduced cost.
When installing Windows, you again have two options:
Upgrade from existing installation. If you don't want to wipe the computer, you can take this option. It will upgrade Windows and try to leave all your files, programs, and settings in place. You can choose this option whether you've purchased an upgrade or full edition of Windows.
Clean install. This option formats the volume before installing a fresh copy of Windows. Again, this option is available whether you purchased the upgrade or full edition of Windows. In the past, an upgrade SKU of Windows would ask for the previous edition's CD for verification that you've owned a full license previously; I haven't seen this in a long time, though, so it might not still be the case.