1 and 2: I can´t think of a situation where this might be a problem? And if it is, you most probably don´t want to use terrain anyway.
3: Shaders are the way to go...
4: Be creative
![tongue tongue](/ubb7/images/graemlins/default_dark/tongue1.gif)
I could imagine a terrain with some transparent parts in it and some regions disabling collision with the terrain. Shouldn´t be very hard.
Edit: Some idea on the topic would be to use a big model moving with the player on a fixed grid based on the vertex distances with a higher vertex distribution at its center. One could then generate an heightmap on the fly based on the position and set the vertex heights within the vertex shader. The collision detection can be done manually with the heightmap image.