i don't think the embedded linux is the solution.
i don't think too, that not using the swap is a good solution. however, you could remake your linux kernel to manage r/w on the drive at the fly, instead of using the swap before. But you'll be confronted to a fragmentation of your partitions.
you could put 32Mo of swap
and 224 for your /
try to avoid installing the whole packages, try to limit. XWindow is one of the best solutions as far it's small (don't attempt to use KDE or Gnome or enlightenment). it's fast, too.
i think it's possible.
by the way, if you've 256Mo of ram, you could (it's a dangerous way if you don't know really) use the /dev/ram file as another partition. you will loose all whenever you reboot your system, but it can be a solution if your system need more disk space for compilation...