How KMS Works
A server acts as the KMS Host, Clients then contact the KMS server. Once the KMS threshold has been met, the KMS host will send a activation request to Microsoft. The KMS Host will then activate the Clients. The KMS threshold is 5 for Windows Server 2008/R2 and 25 for Windows 7. If there are not enough clients to meet the threshold for activation then they will report to the KMS Host every two hours until the threshold is met.

KMS Host Keys Matched to Products They Activate
There are several key types. The table below, taken from TechNet, explains which type of key should be used and what they will activate. For example if you only have Standard and Enterprise Server you will only need KMS B key.

slmgr
Microsoft tool for configuring and managing activations from Windows. A few useful commands working with KMS.

slmgr /dlv
This will give you information regarding your software licensing service. Use this to check the client count contacting the KMS Host.

slmgr /rearm
Rearms the activation using the existing product key.

slmgr /upk
This will uninstall the product key.

slmgr /ipk <Product Key>
This will allow you the enter or change the product key.

slmgr /ato
This is the command line to activate windows.

nslookup -type=srv _vlmcs._tcp
This will tell you which server is listed in DNS for Volume Licensing. Basically what server is your KMS Server.

Need Default KMS Client key?
Microsoft provide the default KMS clients keys on their TechNet help site. Vista & Server 2008 here or Windows 7 & Server 2008 R2 here.

Installing Windows Server & Windows 7 Using KMS

First Server installation of Windows Server 2008 or R2
If you have not used KMS before and you are installing your first Windows Server 2008 use a KMS product key from your licensing agreement. This will act now as your KMS Host server. This product key will activate with Microsoft.

Further Server Installations of  Windows Server 2008 or R2
When it give you the chance to enter a product key do not enter anything, it should by default use a built in KMS Client key. Should you enter the same key as your first server or any other KMS product key you will have two servers acting as KMS Host. This is OK only if you PLAN to have two KMS Host servers. If you entered a KMS product key and realised you shouldn’t have, then we need to replace this key with a default KMS Client key.

Open a elevated command prompt and use the following commands. A restart will most likely be required after uninstalling the existing product key. You can find the KMS Client product key here (Vista & Server 2008) or here (Win7 & Server 2008 R2) , scroll down till you find the KMS Client Setup Keys.

slmgr /upk
slmgr /ipk <Product Key>

Installations Of Windows 7
Use the same guidelines as Further Server Installations. A default KMS client key is built into the installation of Windows 7, you will notice when installing it will not ask for a product key.

Activating Windows 7 with Windows Server 2008 (not R2)
You will most likely encounter problems when trying to activate Windows 7 when you have a Windows Server 2008 acting as a KMS Host. The problem here is that the KMS Host only knows about Vista and Server 2008, not Windows 7 and Server 2008 R2. An update has been released that updates Windows Server 2008. Once the update has been installed on the KMS Host the server will need to be restarted. You will then need to update the KMS Host with a KMS Server 2008 R2 key, even though you are only running Server 2008. You can find the KMS Host key from your licensing agreement.

slmgr /ipk <Product Key>

Followed by a stop and start of a KMS Service

net stop slsvc

net start slsvc

You should then find your Windows 7 can contact the KMS Host. If the threshold is not met, it will report that it could not activate. This is perfectly normal and you should not worry.
However it is advisable that if your long term plan is to have a number of clients under the threshold then you should consider using MAK keys instead.
See here for when to use MAK and how to convert to it.

For more information regarding KMS and activation then the Volume Activation Technical Reference Guide is a good place to start. It can be found here.