step 2

ok, by the way, you will probably want to mess about with a packet sniffer at some point, so install one now. I recommend wireshark (previously called ethereal). Just apt-get it if you are in ubuntu, or yum if in fedora, or just install from source.

Now, to redirect communication to your machine.

Since you already set up the xbox to use your machine as the gateway, the packets are now coming to it. Trouble is, they are either getting routed on to the real server or being ignored, to change this you need to use iptables, install it if you don't have it.
use the following command:

iptables -t nat -A PREROUTING -s 192.168.0.18 -j REDIRECT

Replace 192.168.0.18 with the address of the xbox.

Well done, you now have a fake xbox live server, too bad it does nothing yet.