In my opinion, it is definitely better to stay in town. Although nice, Mountain Village can be rather sterile. The town kicks ass - great food, lots of character, and the best main street view of any ski town in the US. The suggestions above are good ones for places to eat. Fat Alley and Hongas in particular are good. Also try Harmon's, La Marmotte, Rustico, the New Sheridan Chop House, or Maggies (for breakfast). The Lodging recommendations above are good too. I also really like the Hotel Telluride. It is cheaper than Camel's Garden (although not real cheap), and very nice. The Bear Creek B&B and the Johnstone Inn are smaller and more quaint (and less expensive).
The town also has interesting galleries and shops (make sure you visit John at the Teluride Angler), and generally has a cool vibe.
It is true that some of the runs down into town are steep, but I wouldn't worry about it. There are easier ways down too, and you can always take the free gondola down.
Telluride is one of my favorite places on earth. You will not regret a trip there.