Well, my first suggestion is going to be "Read The Manual". It is part of the extras that come with the game. Some of your questions here are really, really basic interface questions; I don't blame you for not knowing, but the manual should cover most of that.
Wide_Arc: I have a Knight-Ranger-Cleric-Sorceror party.
Q1: Is that party viable? I don't care if its sub-optimal, just don't want something game-breaking.
Your KRCS (Knight-Ranger-Cleric-Sorcerer) party is viable, but I suggest dumping the Ranger for a Thief because the Ranger does not bring anything unique to the party. He does some of what each of your other characters do, except not nearly as well as they do it. He swings an axe quite well, but he doesn't have the other combat abilities of the Knight. He can cast basic and expert Self magic like your Cleric. He can cast basic and expert Elemental magic like your Sorcerer. The Ranger has access to a wide range of skills, but he doesn't do any of them very well (except swing an axe).
I suggest the Thief because the Thief can also fight, but the Thief brings GM (Grand Master) Disarm Trap to the party, something none of your other party members can do. If you do take a Thief, then don't invest anything in the Stealing skill; Stealing is generally a worthless skill. The Thief doesn't have any appreciable magic ability, however.
Wide_Arc: Q2: Is there a guide (or can someone explain) how combat actually works?
Probably. I suggest reading the manual first, then asking more specific questions about things that you didn't understand or that weren't explained. This question is simply too broad to cover effectively.
Wide_Arc: I am ashamed to say that I've spent most of my time so far getting team wiped by dragonflies and rats. I've figured out that I can go into turn-based mode, and how to cast my Cleric's heal spell, so that helps a bit. But a lot of the time I can't understand which of my party is actually having their turn, or how to understand who the monsters will attack (is it just random?). My Sorceror has a firebolt supposedly queued up as the quick spell, but in combat it's never available, so she's useless. My Ranger has a crossbow and seems to use it when her portrait is yellow (ie. ranged?), but then I don't know what she's doing at red (melee)?
-Be aware that you'll periodically be able to move a few steps while in turn based mode. Make use of this feature. You can run or walk forward, or you can walk backward. While you can strafe to the side, there really isn't any reason not to just turn to the side, move, then turn again to face whatever direction you want to face. If you want to backpedal faster, then turn around, run, and turn back to face the monsters when you are out of movement.
-Your characters will use whatever weapon(s) they are holding that is relevant to the attack they are trying to make. If you aren't holding any weapons, then your character will default to using their fists.
-Use the "A" key or click on a monster to attack. If the character has a ranged weapon equipped AND the target is out of melee range, then the character will fire their ranged weapon at the target. Otherwise, the character will make a melee swing at the target (and always miss if the target is out of range).
-Use the "S" key to cast whatever spell you have set as your quick spell. If you don't have a quick spell set, or if you don't have the mana for it, then the game will act as if you hit "A" instead.
-Open the spell book and click on a spell to have the active character cast it. If they don't have enough mana, or if the spell can't be cast in current conditions (ex. Starburst can only be cast outdoors), then the spell will not be cast.
-The active character has a highlight around their portrait. Experiment some by walking out to the shore, turning away from any townspeople, and hitting A. One character's portrait should lose the green "hourglass" coloring, and someone else should become highlighted. Take a look at the screenshot I've attached; I've drawn an arrow pointing at the guy with the highlight.
-The color of the hourglass around each member of your party is an indicator of the proximity of hostiles to your party. Green means that no hostiles are nearby. Yellow means hostiles are in range (and probably making some attempt to either attack you or get in range to attack you). Red means hostiles are in melee range of your party.
-The hourglass is lit (regardless of color) for each character that is ready to take action. Every time a character takes an action, they'll need to have some time to recover before taking another action. Some actions are inherently faster than others: swinging a sword needs more recovery time than swinging a dagger, and casting a resurrection spell on someone takes significantly longer to recover than a casting a "Cure Weakness" spell. If the hourglass is not present, then the character is recovering from their previous action.
-Certain monsters prefer to attack certain races of character (ex. goblins tend to target dwarf party members more than others), certain monsters prefer to attack certain classes of character (ex. ghosts tend to target clerics), and certain monsters prefer to attack certain genders of character (ex. titans tend to target females). Beyond that, I believe targeting is basically random.
Wide_Arc: My knight seems to be doing what he should - ie. hitting quite hard - but I keep getting swarmed by dozens of dragonflies, or blocked in by dozens of rats, and it's all over pretty fast.
One tip: monsters generally just stand still until you move within their "activation" range. In other words, they'll just stand at their spawn point until you move close enough for the game to start moving them around. Keep the wizard eye spell active and watch your mini-map in the upper right corner; red dots are hostiles. If you move carefully, sometimes you can activate just a few of the monsters at a time, which will help you avoid being swarmed. Deal with them in smaller groups. Also, run away if the monsters start to overwhelm you; they are likely to give chase, but you can outrun most monsters in this game if you have the room to move around.
Wide_Arc: The thing that's really confusing me the most is the lack of clarity about which character's turn it is... surely I'm missing something obvious on this. But for example, I'll press attack, my knight will hit something, and then it shows my Ranger and Cleric with a red surround. I don't know which one is meant to be acting next, so if I hit attack, maybe the Ranger will atttack, maybe the Cleric... when actually if I knew it was the Cleric, I'd have cast Heal.
Characters are generally queued in the order in which they recovered from their previous action. If everyone attacks, and your characters recover in order of Knight-Sorcerer-Ranger-Cleric, then that's the order that they'll highlight when the active character takes his turn. If you are NOT in turn-based mode, then you can also click on a character's portrait (if they are ready to take an action) to make them the active character (the tab key can also cycle between active characters).
It is entirely possible for very fast characters taking actions with short recovery times to get multiple turns before slower characters recover from an action.
Wide_Arc: I assume this is a game worth sticking at - although I play more modern stuff these days, my favourite games were Ultima IV/V and Bard's Tale 2, so this should be right up my alley surely? Just struggling a bit to get into it!
Many people would say the game is worth sticking with it. Having completed it multiple times, I'm one of those people. :)
Again, I strongly advise you to read the manual first for basic information on interacting with the game. Feel free to ask more questions if things aren't clear.
Edit: Added some clarifications.