Permalinks and static Home Page

I’m trying to configure wordpress with a static home page and search engine friendly links. The static home page setting under options>reading works ok but when it comes to the permalinks I want to use
/%category%/%postname%/ but it doesn’t work.If I use
/index-php/%category%/%postname%/ then it works but the links look like:
index.php/cat1/newpost
which I don’t want.
I’ve been looking through the codex and see lots of talk about .htaccess but its not being used on my setup (windows xp/apache/mysql/wordpress)
I also notice a mention of internal url rewriting but can’t find any more info on it . Is .htaccess still used or is the rewriting now done in php code somewhere?
If .htaccess is still being used any ideas why wordpress isn’t creating one on my system?

One last thing when I hover over the page links they show up with the full url https:// etc but I would prefer relative links. Where do I configure this?