Live wallpapers were added in 2.1, so it simply does not make sense to try to show a live wallpaper on a 1.6 (or 2.0) device.
In 2.0 the Theme.Wallpaper theme style was added, which as the new official way to put an activity (or window) on top of the system's wallpaper (live or not). Of course, since this appeared in 2.0, you also can not use this in 1.6.
Prior to 2.0, the only way to display on top of the system wallpaper was to use getWallpaper() to retrieve the static wallpaper image, and take care of drawing it yourself in your UI. This of course can not support live wallpapers.
If you want to have an app that shows in the wallpaper on both pre-2.0 and 2.0 and later versions of the platform, you will need to check the API version in android.os.Build, and adjust your behavior appropriately: when initializing your activity, if 2.0 or later use setTheme to choose the wallpaper theme; otherwise, get the drawable and make it the background of your UI. When using the wallpaper theme, you need to make sure your UI does not draw an opaque background on top of it and cover it up. You may also want to try setting your activity's theme to Theme.Translucent, to get better behavior on 2.0 or later (where ideally you would use Theme.Wallpaper which also gives you the proper animations).
Actually, you could conceivable use versioned resouurces to make your own theme that adjusts appropriately depending on the platform version (either a wallpaper or a traditional theme). I have never tried to do this, though.