Proper Multi-Seat X Support Is On The Way
Red Hat was wanting to deliver a good multi-seat implementation with Fedora 11, but that feature ended up being recalled and postponed to the next Fedora release, Fedora 12. Rather than mixing X.Org and Xephyr, a cleaner way of handling this would be to just start up multiple X Servers so that each seat would have its own X Server. If you do that right now though, you could run into some issues when you have multiple X Servers and multiple graphics cards, etc.
To work around this issue of multiple X Servers colliding with one another when talking to the graphics cards, there was a revival of the VGA Arbiter back in May. The VGA Arbiter was first designed nearly five years ago and its goal was to allow multiple X Servers to run with multiple graphics cards having the legacy VGA interface without causing any problems. Tiago Vignatti has now revised this VGA Arbiter work from earlier this year (along with the help of David Airlie) and he has now submitted a new VGA Arbiter implementation to the Linux kernel mailing list.
The VGA Arbiter hasn't made its way into the mainline tree yet and there are also some other patches that need to work their way upstream when it comes to the X Server and libpciaccess. However, once done, this should be a large step forward in improving the Linux multi-seat experience. Tiago has briefly talked about this work on his blog.