Windows ME would likely work fine, for various values of fine. It'd be somewhat slower than Win98, plus ME has issues of it's own. Win98SE is really the sweet spot for a 1200 (as far as Windows goes).
XP might install, but it'd be very slow. 1200's max RAM is not really enough, and the processor doesn't have the oomph to make it pleasant. There are some reports of getting Win2k on a 1200 in here, and apparently it does all right so it might be an option if you need an NT-based OS.
As for the pen, the standard Pen Services 2.0 might work in ME, would probably work in 98, but definitely won't work in 2k/XP. I don't believe anyone has them working on a 1200 with a pen.
If all you're looking for is a basic surfing pad, you might look into some of the various Linux distributions. It does very well for that sort of thing.