The data being deleted is in reference to the data already stored on the phone (e.g. the sister's contacts). An iPhone can only be synced to one PC at a time, and if you want to setup syncing with this new PC, you will need to delete all of the data on the iPhone.
If your wife wants her sister's contacts, then she shouldn't sync and wipe the data before she has a copy of all that info. One way to to get the info on to the iPhone is to sync it with outlook (via iTunes) on the sister's PC. Then export the contact's from Outlook, copy the file to the wife's PC, import into Outlook. Then proceed ahead with the sync that will wipe all the data, and set it up to sync with Outlook. This way your wife will have all the original contacts.
If your wife does not care about her sister's contacts, then you can go ahead with the initial sync that wipes all the data.
When the phone is synced with Windows 7, it will use the following folder for backups: \Users\(username)\AppData\Roaming\Apple Computer\MobileSync\Backup\. Therefore, you should back up that folder if you want to keep a second copy on your computer.
If the most important data that will be used on the phone is Contact information, I would recommend that instead of using Outlook, that your wife use Google Sync. This will allow her to store all of her contacts in Gmail, such that if anything happens to the phone, the contact info can easily be accessed again online, all without ever having to sync or backup (or double backup) the phone. Google Sync can also sync your Calendar. If you setup a Google account as IMAP, you could even have the Notes synced to the cloud as well.
Keep in mind that when the data gets wiped, everything on the phone will be deleted. This includes, but is not limited to, the following:
- Music
- Videos
- Podcasts
- Address Book and Address Book favorites.
- App Store Applications and their data.
- Application settings, preferences, and data.
- Autofill for webpages.
- CalDAV and subscribed calendar accounts.
- Calendar accounts.
- Calendar events.
- Call history.
- Camera Roll (Photos, screenshots, images saved, and videos taken.)
- In-app purchases.
- Keychain (this includes email account passwords, Wi-Fi passwords, and passwords you enter into websites and some other applications.)
- List of External Sync Sources (Mobile Me, Exchange ActiveSync).
- Location service preferences for apps and websites you have allowed to use your location.
- Mail accounts.
- Managed Configurations/Profiles.
- Microsoft Exchange account configurations.
- Network settings (saved wifi spots, VPN settings, network preferences).
- Nike + iPod saved workouts and settings.
- Notes.
- Offline web application cache/database.
- Paired Bluetooth devices.
- Safari bookmarks, cookies, history, offline data, and currently open pages.
- Saved suggestion corrections.
- SMS and MMS (pictures and video) messages.
- Trusted hosts that have certificates that cannot be verified.
- Voice memos.
- Voicemail token.
- Wallpapers.
- Web clips.
- YouTube bookmarks and history.
(This list was slightly modified from Apple's page)
Currently, there doesn't seem to be a way to prevent iTunes from pulling in the voice memos. The closest I've been able to figure would be to have a script or launchd item that simply removes anything that it sees. Preferable copying them to another directory for storage.
Update: October, 2017
I've switched to using Just Press Record which is dedicated to voice memos. It's fast to start and also creates transcripts. They're pretty good most of the time, but sometimes they get pretty far off. It's a nice feature, regardless.
The app costs a few bucks, but it's well worth it. (And, I like to support developers so they can keep working on software I like.)
Best Answer
You can restore the device by cancelling the restore of the backup, then selecting Restore iPhone in iTunes. This will reset it to the original state and allow you to set it up without the backup.