its your windows disc.
the cd doesnt have SP2 on it does it? thats because they added compatibility with higher than 127gb hard drives with sp1 or 2.. i dont know which one it was with but my disc has the same problem...
you should be able to update windows and then format the rest of the drive... ultimately having two partitions on one drive. if you don't want to do that then you'll have to format the drive with another computer, or use a smaller drive as your system drive.
what i did was i put windows on a smaller drive something like 20gb and i then proceeded to update that windows, until it let me reformat the drives bigger than 127gb... went into drives manager and formatted my drives that are bigger than 127gb... then i could put windows on whatever drive i wanted without reformatting using the windows disc.