See a similar thread I started:

http://www.flyertalk.com/forum/Forum94/HTML/004653.html

FT'er greggwiggins is, IMHO, an outstanding expert on Key West. He gave me more tips through email than you can see in the thread above. You may want to email him. He recommended to me a stay at the Conch House Historic B&B. It seemed like a great B&B, as B&B's go. It was my first B&B experience, and I decided I don't like B&B's as a class of accommodations, but if you do like them, then the Conch House is great.

Among larger hotels, the Hyatt, Wyndham, and Hilton offer central locations with a beach resort sort of atmosphere. The Crowne Plaza La Concha has a great location, but the hotel itself is mediocre, and no beach access. The Sheraton Suites is across the street from Smathers Beach, but kind of far from town.