I think the -r flag tells dsme to reboot the device if this process dies/is killed. I.e. if Xorg goes down holy sh1t, catastrophe! Reboot now!
Possibly by changing the dsmetool flag for xorg startup you could change the way it reacts to Xorg dieing. For example if you copy how BME is launched (just restarts BME if it is killed/dies, reboots after 5 shots) you may get your desired effect.
The watchdog is a timer that runs out, a hardware countdown. If some piece of software does not set a bit every 30s (I think) then the hardware assumes everything has gone tits up and resets the hardware (reboot).
So the problem is not the watchdog killing the phone, it is dsme killing the phone when it sees a critical process dieing. You just have to change how dsme starts xorg.
I gues Xorg.0.log is copied to /home/user so that you can actually have a look at the log in case it's necessary.
This is done at /etc/event.d/xomap, where BTW you can change the startup options (look for variable "XORG_OPTIONS") as well as the parameters for dsmetool (remove "-r" if you don't want dsme to reboot the N900 when X dies or is killed -> but then you'd need a framebuffer as well as a way to change to another virtual terminal, and obviously a listening terminal (getty)).
The cp /tmp/Xorg.0.log /home/user is done by the post-stop script, which presumably happens when you (cleanly?) reboot the N900.
