You didn't think to ask about brakes-you should have. Since gravel has less grip (therefore less weight transfer), the front-biased braking of street cars makes no sense. Gravel braking performance gets much better by simply removing the proportioning valve that reduces rear brake force on a stock braking system.
Differentials in rally depend on driving style as anything else. Foot-to-the-floor drivers who hurl themselves into corners and work out the details later often find a welded diff perfectly suitable. The more subtle, who feel for grip through the whole corner and make tiny adjustments on the fly, complain that locked diffs give either full oversteer or full understeer, with no room for finesse in between. We prefer a looser diff, either a helical or a relatively loose clutch diff, or even an open diff on a rear-driver. Only the clutch diff or the welded diff, though, will get you out of a ditch if you have one wheel in the air.
As for the bet with your friend whether front-wheel-drive cars can be just as fast as all-wheel-drive ones, it all comes down to the word can. Every experienced front-drive rallyist can look back and find a few all-wheel-drive cars behind him, so yes, they can be just as fast. In all but the most unusual situations, though, it's an all-wheel-drive car that ultimately wins the rally.
Front-drivers can't make use of much more than 200hp. Anything more just goes into churning gravel. At that power level, equally prepared front-drive and all-wheel-drive cars will be very close, with an all-wheel-drive car allowing the driver to get on the gas just a bit earlier in each corner.
A well-prepped all-wheel-drive car, though, can make use of up to 400hp (though most classes restrict them to less), so given the freedom to break the 200hp barrier and given equal drivers, the all-wheel-drive car will win every time.
The advantage of all-wheel drive doesn't make it the right choice for most, though. Front-drive rally cars are much cheaper to race and, since they never run in the same class as all-wheel-drive cars, there's just as much opportunity for victory. Starting with the 2007 season, more prize money is available in front-drive than in the all-wheel-drive classes, thanks to the privately funded MaxAttack! Championship (www.max-attack.com).
Feed your need for knowledge at www.rally-america.com, www.specialstage.com, and www.rallyanarchy.com. Then, when you realize you can't afford to rally, go do some rallycross instead. Everything I said about breaking stuff and hitting trees doesn't apply in rallycross. With shorter abuse sessions, smoother surfaces, and almost no trees, even stock cars can do rallycross. Just a suggestion: Avis is your friend.