Apple Posts Upgrade to iPhone 2.0 Firmware Guide
Apple has posted a guide to help you when upgrading your iPhone to the 2.0 firmware.
You can use iTunes to update or restore iPhone or iPod touch software. Apple recommends updating iPhone or iPod touch to use the latest software. You can also restore the software, which puts iPhone or iPod touch back to its factory condition.
Normally if you choose to update, the iPhone or iPod touch software is updated but your settings and media are not affected. If your device currently has a software version prior to 2.0 (1.x) and you are updating to software version 2.0 or later, all data on your device will be erased in order to perform install the new software. In this case, iTunes will offer to create a one-time media backup of your device depending on what content is on your device and what content is stored in the iTunes Library you are connected to. You should ensure that you have enough free space on your Mac or PC to accommodate a backup that matches the capacity of your iPhone or iPod touch (4 GB, 8 GB, 16 GB, or 32 GB) if you proceed with the this backup.
If you choose to restore, all data is erased from iPhone or iPod touch, including songs, videos, contacts, photos, calendar information, and any other data. All iPhone or iPod touch settings are restored to their factory condition. Whenever you update or restore your iPhone or iPod touch software, Apple highly recommends that you perform a sync prior to the update in order to back up any changes since your last sync. If you have movie rentals on the device, see this document before restoring.