Providing them with individual versions that they configured isn't a problem at all, even on a per-directory basis. You can do that with Apache and some configuration.
The actual problem is more complex: you always have the conflict between wanting users to use the latest version (because of security issues or stuff like that) and not breaking the software they're running.
Actually 1and1 is running 5.2. Some web software does meanwhile requires 5.3. After all software will break even when there is no upgrade at all.
Anyway, i fully agree: providing hosting is a hard business. Imaging what 1and1 needs to do for this huge server farm... wow. It's ok for a lot of low traffic sites without much functionality, but in my case I needed more at one point. Now I have the choice between 5.3 and 5.4. Thats neat.
The actual problem is more complex: you always have the conflict between wanting users to use the latest version (because of security issues or stuff like that) and not breaking the software they're running.