Whew boy, that is the $64,000 dollar question. The only consensus at the moment among western academics is that the hadith are incredibly problematic as source material. When faced with that problem the responses among Western academics range from the late great Patricia Crone who would advocate throwing it out entirely to Jonathan Brown who, though I'm afraid I haven't read his book, I understand from watching his lectures that he basically concludes that Islamic hadith science involved enough scrutiny and rigor that they are in fact reliable.

The problem in very simple terms is basically whether to assume a given hadith is false until proven correct, or correct until proven false. Robert Hoyland's Writing the Biography of the Prophet: Problems and Solutions is a great and succinct overview of the historiographical problem that the hadith pose.

As background, among the problems with using hadith as a historical source are:

1. We know that hadith were being fabricated en masse
2. We know that hadith often reflect political polemics in the 9th century rather than the 7th
3. They consist of oral traditions that weren't written down for a couple hundred years
4. They are often contradictory
5. They often seem to become more elaborate the further from Muhammad's lifetime you get.
6. Even if you assume that some portion of them are true, that there is some "kernel of truth" to them, it is largely impossible to separate wheat from chaff. Methods that purport to know how to do so are subject to scrutiny as being arbitrary or based on assumptions with no basis in fact from the sources we have.

One of the primary "solutions" to this has been to look outside the Islamic traditional sources and instead try to corroborate or craft a new narrative of early Islam using non-Islamic sources or the limited documentary sources we have access to. Hoyland's In God's Path is a good reflection of that approach.