Will a Custom Recovery work with an encrypted device? I wanted to know whether using Android's built-in encryption (introduced in 3.0) would affect my ability to use a custom recovery (Clockwork Mod in my case).

More specifically if I will still be able to perform Nandroid backups/restores and flash new files and updates?
Yes, custom recovery works with encrypted honeycomb device. The built-in encryption doesn't touch ROM &amp; firmware at all. It just encrypts accounts, settings, downloaded apps &amp; their data etc. which can be located on phone memory, internal SD or external SD. That's why encryption is no longer present after factory reset because there's no encrypted data available.

Files for custom recovery environment live on ROM as firmware. That's why they survive factory reset. As Flashing files/updates has to do with ROM, you'll be allowed to do it. When it comes to Nandroid backup, you can do it too, but the chunk of encrypted data will backed up in that form which can't be restored using Titanium Backup. Yes, you could do Nandroid restore flawlessly.