Actually, the default behavior for IE is to open Office documents in the browser via the plugin, which I think is what you want. Most of the help you'll find scouring the web is people wanting to go the other way: to force it to open in the Office client. Here is Microsoft's official support document on the topic:
I cannot find anything to walk you through the reverse of this, but perhaps you could reverse engineer the steps in this document to come up with your solution.
I think what you are saying is that you want your master page to be visible/active when the user opens a document, and you want said document to be displayed in the editable region of the page. I don't think this is possible in SharePoint 2007. The problem is going to be that the browser plugin will open the documents full-screen anyway, hiding your master page.