If you haven't booked the hotel yet, give the Southernmost hotels a good look:
http://www.southernmostresorts.com/
Cheap rates for Key West (under $200 a night during the offseason; about $300 a night this time of year, but it's still cheap compared to other places in Key West), decent enough rooms and a great location on the quiet end of Duval. It's on the south end of Duval, which is about 2 miles end to end, but you can easily walk it and take in the scenery or rent a scooter.
As for stuff to do, make sure you hit Mallory Square at least one day at sunset and watch some of the street performers. I'd also recommend a sunset cruise. There's a pirate schooner that goes out for about a two-hour cruise for around $35 per person.
The pirate museum is worth an hour or two, but stay away from the Mel Fisher museum (it's rather boring). There's an art museum in the Customs House that might be worth a visit depending on the exhibit.
Also, make sure you stop and give the dirty joke man on Duval a dollar. He'll make you laugh.
Food?
The Margaritaville Cafe is overrated and overpriced, but my wife swears by their Key West shrimp.
Caroline's on Duval is a great little outdoor lunch place with decent food and people watching.
The small beach near the Southernmost Hotel has a little cafe. Food is OK, and eating on the beach is pretty cool and relaxing.
Basically, just walk up and down Duval and see what strikes your fancy. Most places have menus on the window.
