"Does this mean that I can use a 160Gb internal HDD"
No you can not. The bios would not see such a large hard drive. It may by using the manufacturers software but it is tricky on laptops.
"Have recently discovered I can operate a 160 Gb on this laptop via a usb caddy."
You can use any size hard drive via the caddy, even a 1TB drive. The only thing you will find is that it is quite slow when you work with large files.
Saying that, an external drive is great for extra space and backups.