Here’s how it works: iTunes determines which songs in your collection are available in the iTunes Store. Any music with a match is automatically added to iCloud. Since there are more than 20 million songs in the iTunes Store, most of your music is probably already in iCloud. All you have to upload is what iTunes can’t match. Which is much faster than starting from scratch. Once your music is in iCloud, you can stream and store it on any of your devices. Even better, all the music iTunes matches plays back from iCloud at 256-Kbps AAC DRM-free quality — even if your original copy was of lower quality.
From here > http://www.apple.com/icloud/features/
Does the user have to manually delete their old versions of songs or are the songs automatcally replaced when a song that has been matched is downloaded from iTunes?
No. Don't delete any music.