Which particular update are you referring to? The .NET framework or the 1.1 service pack? No harm in installing the update, not sure if 2.0 builds off of 1.x, which may be why you are being prompted to install it.
1.1 and 2.0 should probably both be installed. They run side-by-side.
.Net 2.0 does not really replace 1.1 - applications written for the 1.1 framework should/will conitinue to look for and use the 1.1 files and applications written for the 2.0 framework will/should look for the 2.0 libraries.