You can swap the drive out for a 120GB drive only and it has to be a Western Digital BEVS model drive - nothing else will work. You also need a HD SS file from a 120GB HD which is technically not legal to distribute so you'll have to obtain one on your own.
If you were to put a larger BEVS drive in, the 360 would still only see 120GB of it so no matter what you do, as of right now you can't have any more than 120GB.
These days I don't think it's worth the hassle. You can pick up a proper MS 360 120GB drive fairly cheaply these days. I sold my spare 360 120GB to a friend for £40 - I've seen them for around £50 on auction sites. When they're that cheap and a BEVS 120GB is around £40 you're not saving that much really.