A: It is always important that you go with your heart, sexuality-wise. We can love people all we want for reasons other than their "junk" (hehe) but in the end, sex DOES matter. You are not going to be able to have a functioning relationship without an eventual degree of intimacy--it's just a fact.
That being said, this relationship cannot continue in any romantic way.
The truth is, there's never a way to truly let someone down easy, so you might as well just tell her the truth. You care for her, you respect her, and you are willing to be her friend, but you are not sexually attracted to women. It would be not only unfair to you, but unfair to HER, if you continued this relationship.
The next part, naturally, is the whole friend thing. I assume that you have a decent amount of non-mutual friends, so hang out with them a little more. Don't shun your old, mutual friends, but don't hang out with them and your ex at the same time. Also, don't trash talk your ex--I don't think you will at all, just sayin'. I guess all of that is common sense. :P
I do think that you will need to separate yourself from this girl for a while, after the whole break-up thing that is. Regardless of how YOU feel, she has made it clear that it would be damn near impossible to remain friends with you directly after the breakup. She has big-time feelings for you, that's why! Now, that's not to say that you can't be friends down the road, but the hard truth is that you simply cannot be around each other for a while. If you lose her as a friend FOREVER over this...well, I hate to sound cliched, but she was just not worth it.
There is nothing wrong with who you are and who you like, and hopefully your soon-to-be-ex will understand that. If she's a true friend, she will. She will recover and move on (romantically), and so will you. Just be honest with her and don't let her guilt trip you into doing something that will eventually leave you both unhappy.
Best of luck. :)