We analyze the dynamics of entanglement in a two-qubit system interacting with an initially squeezed thermal environment via a quantum nondemolition system-reservoir interaction, with the system and reservoir assumed to be initially separable. We compare and contrast the decoherence of the two-qubit system in the case where the qubits are mutually close-by ('collective regime') or distant ('localized regime') with respect to the spatial variation of the environment. Sudden death of entanglement (as quantified by concurrence) is shown to occur in the localized case rather than in the collective case, where entanglement tends to 'ring down'. A consequence of the QND character of the interaction is that the time-evolved fidelity of a Bell state never falls below 1/√2, a fact that is useful for quantum communication applications like a quantum repeater. Using a novel quantification of mixed state entanglement, we show that there are noise regimes where even though entanglement vanishes, the state is still available for applications like NMR quantum computation, because of the presence of a pseudo-pure component. © 2009 EDP Sciences, SIF, Springer-Verlag Berlin Heidelberg.