How does Drupal 7 Load its Modules
Is this a "legal/normal" setup?


It's perfectly legal, and yes it's normal for modules that need or want to break their functionality down that way.


  Does nesting one module within another confer any special features between the two modules?


No, they’re just standard modules.


  Where in the drupal source code are modules searched for/loaded?


I think this is pretty much exhaustive for Drupal 7:


/modules/**
/profiles/*/modules/**
/sites/*/modules/**



  Is there any canonical piece of documentation that covers how module loading works?


I wouldn't have thought so - following the code is probably the best way to understand how it works. Core is pretty well commented.