Windows Phone 7.0 is built from the same core building blocks as its Windows Mobile OS predecessors: A Windows CE/Embedded Compact layer at the base, with a bunch of mobile customizations on top. In other words, the Windows Phone team is an OEM of Windows CE/Embedded Compact.
There still seems to be a bit of confusion as to which version of Windows CE is going to be in the first Windows Phone 7 devices that ship this year. A May 3 Microsoft blog post states that the core of the Windows Phone 7 will be Windows Embedded Compact 7.0, codenamed Chelan. The exact statement by Embedded Technical Evanglist Oliver Bloch: By the Way, Windows Phone 7 is based on the Windows Embedded Compact 7 core.
Who cares which version of Microsofts embedded platform is inside? Well, Windows CE 7.0, the Chelan release, includes a handful of interesting capabilities not available in the current Windows Embedded product. WMPowerUser has a nice list of these Chelan features: Dual Core Support (SMP, ARMv6), IE 7 rendering of rich media plug-ins, DRM, Bluetooth 2.1 support and more.
Windows Phone 7 is based on the Windows Embedded CE kernel the next generation of the Windows Embedded CE platform will be Windows Embedded Compact 7 when released, and the current version is Windows Embedded CE 6.0 R3. Although Windows Phone 7 was built on the Windows Embedded CE kernel at its core, the Windows Phone team has incorporated innovative features and functionality on top of the platform to develop an OS specifically designed to meet the needs of mobile phone manufacturers.
As (Embedded Compact) 6.0 is in market, the phone is based on the current version.
In case anyone might think the Microsoft Research project codenamed Menlo could end up derailing Microsofts current practice of using Windows CE/Windows Embedded Compact as the core of Microsofts Windows Phone 7 in the near term, think again