The File Compare tool really isn't much more than an opportunity for you to execute a DOS command. So to really understand how it works, you'll need to dust off your old DOS books.
The answers to your questions really depend on what application you are using for your compare. i.e. Word is going to accept different parameters than perhaps the DrawCompare tool. Bottom line, the tool you choose to compare with is going to need to be started via the DOS command line that you build in this interface.
The %1% represents the file name of the fist document you have chosen to compare, the %2% represents the second. You can use these if your compare tool will accept command line parameters.
I've written on this topic a few times in the past, maybe these will help? http://www.3dvision.com/wordpress/tag/compare/
There is an article in there about using Word as a compare tool.
As far as viewers go, you'll never find a viewer that can display everything. eDrawings does a pretty good job, and the price is right. Same for the viewer that is built into EPDM.
AutoView is a big boy viewer than can be used for many CAD types, but it is rather costly.
I would like to take this discussion in another related direction. The reason I wanted to setup the compare function was to view two different versions of a file. We have "Use latest versions" set by default, which prevents us from getting previous versions but ensuress we are using the latest and greatest design. I want to compare the redlined version of the document and the changed document side by side to see if the changes were made correctly. I am sonewhat leary of disabling the "Use latest versions" setting. Have you run into any major issues with this setting being disabled? How is yours set?
From the file history window you can select a version (or revision) and click the View button. The EPDM viewer will open a new window with that file shown. You can repeat this for a different version/revision and you will have two windows you can compare side by side.
This works regardless of whether or not the 'Always Work with Latest Version of Files' option is enabled or not.