The guest instances are fully 386 Enhanced Mode instances of Windows 3.1. Windows 3.1 (and Windows/386 and Windows 3.0) is implemented as an 80386 DPMI server, much like the DOS4GW you used to play Doom, and the the actual GUI code is a DPMI client. Windows 95 is also a DPMI server.

Windows 3.x could also run in “standard mode”, where it used a 16-bit only DPMI server. The Windows GUI system could run in real mode or as a DPMI client.

As far as “nested virtualisation”… Windows 3.1’s DOS windows could actually in turn run more instances of Windows 3.1, because Windows/386 relied on virtual 8086 mode only and Windows 3.x used DPMI which can be nested.