Illyria's actually an old one. IIRC one of Buffy's first major adventures was to prevent an old one from coming into the world -- wasn't that what the whole Acathla thing was about?
Anyway, one of the bad guys on Angel managed to summon an Old One, which is basically a pure demon. It -- or she, since she's in a female form and I figured calling her "it" in the story would confuse some of the readers -- is ancient, has little frame of reference for our reality, and desperately misses being a demon god. She's truly an alien entity. She's still a force to be reckoned with but she's been neutered (because she was ripping reality apart at the seams) by Angel, Spike, and company.
When the bad guys summoned her they summoned her into Fred's body -- Fred was the show's resident geek (every fantasy/sf show has one) -- much beloved by the other characters and frankly by the many of the viewers, as well. When Illyria possessed Fred's body she didn't just "kill" Fred -- she destroyed her very soul.
But this wasn't actually Illyria's fault (Illyria was summoned by the true bad guys) and she turned out to be a shades-of-grey character, too alien to be really evil. Too powerful to be killed, also, and anyway -- not truly evil and Angel had bigger things to worry about. She got along well with both Wesley and Spike. (If beating the snot out of Spike could be considered "getting along well" with him.)
As far as Giles recognising Illyria -- I can't recall him ever meeting Fred on screen on the show, though Fred was around for a few seasons and I'm assuming that the name got mentioned in passing in the context of Winifred Burkle being one of Angel's people. WILLOW has met her. However, given that I actually had to check the credits to verify that Illyria was truly being played by Amy Acker because I as a viewer had a very hard time seeing Fred in Illyria ... I'm going to say that the blue hair/eyes and the very different body language works about the same as Clark's glasses. *Grin* Nobody's going to recognize Illyria as Fred.
As far as Spike meeting Bill first -- yeah, that's a minor setup for a sequel.
I figured the two of them would get along well and have chemistry. (Can't you just see Spike, Buffy, AltLois and Bill in Clark's world? Particularly a meeting between the two Loises ...)
