I'm not sure why I think this, but I had them impression that they use it for test environments, but I'm pretty sure they also use it to provide "cloud" desktops for employees, I think I saw reference to it in a presentation about the open source NX server they released a little while ago.
They don't use virtualization for any of their normal infrastructure -- it's much more productive to have locality with GFS/BigTable/memcache/App/etc all running in the same OS image on every machine.
I do see them having plenty of use for virtualization when provisioning machines to run non-infrastructure, their client software, other people's software, etc. Its usefulness for software testing should be obvious.
I don't know if they use full x86 virt. for it, but your App Engine processes have several layers of OS sandboxing around them.
