Nura,
I don't know what country you will buy in and what the prices there are like. I don't know what prices in India are as I have not shopped for audio in India for the last 14 years. Your $500 - $900 budget, do you intend for it to include the subwoofer? This amount of money will buy you only a weak subwoofer, and choice of F/C/R speakers that either sound good, or can produce large SPL, but not both. The subwoofer will not be a true sub, but will instead be a sort of "bass reinforcement module" even if they call it subwoofer. A true sub will will have a very solid response to down to near 25Hz, if not 20, and would generate atleast 100db in the 30 to 60Hz region without distortion. It is virtually impossible to create this kind of performance for low cost. A typical $300 sub will roll off rapidly below 40Hz, and produce almost no output at 30Hz, and will almost certainly not manage 100db without distortion in the low band. So in essence, what you get is a "woofer" not a "subwoofer".
One very good system for $600 (in the US), is the Mirage Nanosat 5.1 system:
NANOSAT 5.1 System
Another very good system was the Energy Take5 system, but I believe its been redesigned and I don't know what the new price point for the Take system.
If you can tell me what brands are available to you, I would be happy to offer you some opinions.
on your other question, the AVR will allow you to listen to your music CD in either stereo, in which case the sound will come out from the front L/R speakers, plus your subwoofer, if you have set up the AVR's settings to send low frequency to the sub. But you will also be able to listen to music in Dolby ProLogic II (or its DTS equally), which will synthesize 5.1 sound from the stereo source and produce sound from all speakers. In addition, there are various sound modes that the receiver can use to simulate various environments like "jazz club" or "dance club" or "mono movie" or "stadium" or "rock concert". If you use one of these modes, sound will come from all the speakers, but mind that these are almost always nonsensical gimmicks and quite worthless. Only Yamaha's high end receivers have received decent reviews for their modes.
As to which will sound best, I find stereo sounds best usually, but then I am a purist with a 9 speaker, 4 amplifier, 3000watt, 4 subwoofer setup, so I don't have to use these modes to make up the deficiencies of my speakers.