http://blog.xna3.com/2007/12/2d-deformable-level.html
I'm trying to do something similar, the above is a good starting point.
I've got it to a point where my projectile is deforming the level once but I have hit a glitch. It only deforms the first time, if I get the projectile to hit the same spot again it seems like it recognizes the fact the terrain was there (even though there is a crater alpha'd out). This means I can never fire into a crater to make it deeper. My first attmept I had the opposite, Once I fired it tunnel through the entire landscape in one hit.
Any ideas?
Mat