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Yes, we should just allow all 1000 players to participate.
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Yeah, why not? Without typing an essay... Automate events, use level instances, separate players into said levels, and combine levels of players as players are eliminated.
I have 0 experience developing for a server that has a player count above 50 so I could just be wrong here, but from I've been told the biggest lag issue in iClassic happens when too many players are in one level. That obviously wouldn't be an issue.
Even if supporting 1000 player events would put too much of a burden on the server, I would imagine it could probably at least support 10 levels of 30 players each? 30% is a lot better than 3%.