Over time the thermostat moving parts corrode.. or more likely get scale on them, so the thermostat stops working.
Ordinarily the 'stat should only open the circuit when the water in the block approaches 86 ~ 88C. but if they stick "open" water from the block can pass freely into the radiator and is cooled before it has a chance to warm up.
It affects mpg because the fuel mixture varies as the water temperature changes. The colder the engine, the richer the ECU makes the mixture (sort of like putting the choke on), The warmer the water, the leaner the mixture (as a hot engine can run leaner without misfiring).
A lean mixture obviously means you're dumping less petrol down the fella's throat. and a rich engine is usually more smokey and the excess fuel can wash oil off the bores, leading to premature ring wear. So, you want it to be as lean as possible, as often as possible to save money and engine wear.
The 'stat is right behind (as you look at it) the coils.. held on with three M6 hex bolts. A new one is about £18 with a new gasket. and if you save 10% on your fuel consumption you'll get the cost back after 4 tankfuls, so it's worth doing.
You just have to undo the bolts, let the coolant **** out
then take off that short rubber hose and lift the stat off the block. It may be stuck by sealant so a gentle tap with a mallet will shift it.
Dry it all off.. shove a cloth in the hole to stop rubbish falling in and then remove all traces of the old gasket with a blunt screwdriver or some non-gauging implement. Remove the cloth and replace the new 'stat using some blue Hylomar (etc.) and new gasket.
Top up the coolant and bleed the system.. but make sure the system IS well bled.. with a dody gauge, you won't see if you have an airlock causing a melt-down.. so I'd say fix the gauge/reading issue first.
Oil only warms up slowly.. so the fact that oil is less than 100C (on a long motorway run) doesn't mean you can't wreck the engine through overheating... but yes.. I guess you'd have found out by now, if the engine was overheating.
The water temp sender is that little sensor next to the thermostat (2 wires going to it, behind the coil pack). If you remove the little rubber Johnnie thing, and pull the wires off, chances are one of the connectors is knacked, bent or corroded .. Clean them up or replace the connectors if they look weedy and see what the gauge says.
Which is the water temp light you mention..? I didn't ever notice one of those.. but then I never went over 95C on mine. The LED on the warning panel (by the ash-tray) is the coolant level
light and that's plain on/off as far as I know.
The wires to the radiator switch activate the fan when the coolant gets to 90~92C so don't mess about with them when you're looking into the water temp' issue - they're a red herring.
The oil temp sensor is the one at the bottom left front of the engine block, left of where the dipstick enters the cases. It has a single wire going to it.
The egg-cup thing (single wire) by the front of the coil pack is the oil pressure sender... probably you know.. but it's often confused with the water temp. jobbie.