I think you're right Matt, the war would be easily won, but the peace would be very, very difficult to win, as per Iraq.I think this is true no matter what China does. If China remains neutral but hostile to an occupying force, reconstruction will be near impossible. But if China gets involved, there will be inevitable tension with the US over who sets the agenda and leads the projects.
Still, at a very basic level I feel that 'Something Needs To Be Done'. My gut says that there should be retaliation for the sinking of the SK warship - and there is absolutely no doubt NK did it. Problem is, how do you get the job done without de-stabilizing the whole region and/or making a martyr of Kim Jong Il?
I personally suspect that Kim Jong Il would welcome a war as a vindication of his paranoia and a chance to go down in a blaze of glory - but I accept your point that if there is a war, he loses his bargaining chip with the masses.
However, I would say that SK doesn't want or need a war for much the same reasons as you give for NK - not least as anti-North posturing seems to be a key part of their politics - take away the threat and what is there to posture about? Just as the people of NK are taught to fear the West, I suspect the people of SK are taught to fear the North - it's a very handy way of uniting the populace and diverting their discontent away from the govt...