open /path/to/iTerm/iTerm.app
Now make it executable (chmod 755 xterm), and live happy ever after.
From now on, X11 will start up and open iTerm instead of xterm. SSH X-forwarding and everything else seems to work all right for me, so there's no drawback to my knowledge. You now have a nice terminal app with full cut and paste support. If you don't like iTerm, you can modify the one-line script to launch any other terminal program.
I know that people will probably not like to replace the xterm binary, but I just wanted to mention this here for those who don't have a problem with that. I would also be happy to see someone post the X11 preference entry which tells X11 which terminal application to use.

