Bit of a thread revival but I've just been experimenting recently.
To clarify:
For sound hardware based games (OPENAL, DirectSound3D - e.g Enemy Terriory: Quake Wars, Oblivion and most games released before Vista came along) CMSS-3D Headphone directly simulates the game environment. Set X-Fi to Game Mode and everything to headphones. If it's DirectSound3D you'll need to set up the game in Alchemy. Ensure hardware audio is selected in game and the correct number of speakers selected if there's an option to do so. If you use speakers rather than headphones I'd advise sticking to 4.0(with CMSS-3D Virtual) due to MacroFX and Elevation Fiter being disabled for 5.1 and above.
For software sound (FMOD, Miles Sound System, Source Engine etc. - e.g Crysis, L4D, Bioshock) set X-Fi CMSS-3D simulates up to 7.1 speakers around you. The software generated game audio is sent to those virtual speakers. To achieve this, set X-Fi control panel to Headphone (hit the Optimize for headphones or Desynchronise button if your drivers have it) , configure speakers in Control Panel sound to 5.1 or 7.1 and ensure the game is set accordingly. If your game supports EAX 4 or 5 (FMOD allows it as a plugin) you will want to be in game mode too. There's no point in limiting to 4 chanels here, as MacroFX and Elevation filter don't work for software based sound.
I may have advised incorrectly in the past, assuming that CMSS-3D Headphone always simulated speakers. It doesn't so where it's supported, hardware headphone mode is a theoretically better solution. The technique advised for software will still work but MacroFX and Elevation filter won't . A happy medium might be always having the Windows and any games run in 4 channel mode - that would kind of cover both bases.
Tis mildly annoying that so many games are taking the software route now. I've not yet heard a suitable substitute for Elevation Filter and MacroFX from a software based sound API.
For the time being I'm still sending 4.0 (audio hardware based games) and 5.1 (software based games) via Dolby Digital Live to a Victor SU-DH1 Dolby Headphone processor. Seems to give me better results than CMSS-3D but there's a bit of latency so can't recommend for competitive play.
Edit: Latest Prelude drivers are working for CMSS-3D by the way. There's no desynchronise from Windows or Optimise for Headphone check-box any more but they seem to have automated the process. Stereo in Windows gives the native headphone mode. 4.0, 5.1 and 7.1 are all simulated with the X-Fi Console in headphone mode. Just configure the speakers according to what you want in Windows.