Information Management Policies are only available in MOSS. The Auditing
settings in these Policies are what you are looking for.

Is it possible to create custom auditing  using the event handlers in
WSS?

Yes, you could easily write an event handler that would do this.

We were looking for a similar solution for one of our implementations
and came across these options:

http://www.invenioworks.com/
2003 product; 2007 product in development (apparently very close to
release)

www.syntergy.com/.../index.html
2003 product; 2007 product in development

MS info on creating custom auditing
msdn2.microsoft.com/en-us/library/bb397403.aspx
www.microsoft.com/.../details.aspx
4B1D-4CB1-B906-6D5D272C8E9D&displaylang=en

And, as Paul mentions, MOSS includes item-level auditing  with an out-
of-the-box GUI.

I haven't used any solution for WSS yet, so I have no recommendation -
just sharing what I can.

And writing an event handler would mean developing a "feature" in terms
of MOSS using VS.NET, correct?

Event Handlers can be installed either using a Feature or the object model.
However, installing using a Feature is actually easier.