Read this Gnoware documentation that my students had written on the working and remastering of Live CDs like Knoppix:
*db.ilug-bom.org.in/lug-authors/anurag/gnoware-final-documentation-1504.pdf
It will clear many concepts like how the kernel bootup is performed, what is cloop driver, what is a compressed ISO9660 filesystem and a lot more.. Fell free to ask more if it feels incomplete.
Also read Knowing Knoppix ebook from here:
*db.ilug-bom.org.in/lug-authors/anurag/knowing-knoppix_2004-12-30.pdf