Story within a story question.

I personally don't see anything wrong with doing that at all. I know a few other authors who have done just that.

Jedi Dad, I agree with jvc. Go for it.

as far as i know, it would be a plus that a version of your story has already been published and the manuscript for your actual novel would be considered brand new and separate

you need to know --what rights did you sell, what reverts back to you and when?

I'm doing that. I wrote a short story and submitted it, but fell in love with the characters. I started expanding the story, and it looks like it's going to be a book. I had an agent tell me that when querying the book (assuming I get there please oh please literary gods and that the short gets published please oh please) it's a bonus, but be sure to tell them. Crossing my fingers she's right.