Electronic – How to set ATmega88PA fuses in code or HEX file

Here is an Arduino Simulator. There's a "Pro" version, which costs $5 now but will later cost $50, as well as a free version with a time-delayed startup but otherwise full functionality.

This isn't a way to debug on the AVR Studio 5 Simulator, but it offers similar functionality within its own IDE:

According to the linked website, it includes the following features:

• Steps through the program line by line. If a new line is selected, the program will continue from that point.
• Performs digitalWrite, digitalRead and PinMode for pins 0-21
• analogRead for pins 0-5 and analogWrite for digital pins 0-13
• Serial output data and input emulation for Serial, Serial1 and SoftSerial
• Emulates LCD output
• If,while,for loop functionality
• Subroutines (multi-level) with arguments
• View variables in real-time
• Step Into, Step Over, Step Out of or AutoStep run mode
• Ability to edit sketch or open in Arduino IDE
• #include code
• Undock output emulation Serial and LCD windows
• Context-sensitive help

See the software datasheet for more information.

CKDIV8 must be 1 (unprogrammed), and CKSEL must be %1111. The rest of the fuse bits are application-dependent and you must read the datasheet in order to determine what they should be.