I will upload a new version of the Sparrow package soon, with iOS 4.0 selected by default -- unfortunately, Apple removed all SDK versions except 3.2 (which is iPad only!) and 4.0.
Concerning the iPod/iPad simulator problem: That made problems on my system, too. But it seems to work when you follow these steps:
First, check if the "Targeted Device Family" in the Project Settings (Build Tab) is set to "iPhone". Back in the main window, the configuration drop down menu at the top left (however that is called) should let you choose the "Active Executable": "iPad Simulator" or "iPhone Simulator".
On my development system, this works: it starts the simulator with the selected hardware type. To switch between old and new iPhone (4G vs. others), I make this choice in the "Hardware" menu of the simulator, and the simulator remembers my decision for the next start. Beware that the iPhone 4 simulator looks very similar to the iPad simulator.
Does this work at your system, too?