Have you ever tried running the virtual hard disk compactor in Virtual PC 2007? Before running this utility, you must defragment the hard disk inside the virtual machine and run the virtual disk pre-compactor.
Virtual disk pre-compactor is available as an ISO on your host machine under C:\Program Files\Microsoft Virtual PC\Virtual Machine Additions. Mount the ISO inside the virtual machine and it will self install.
Virtual Machine Additions are installed by default with Virtual PC 2007 but you must install the service pack to get the pre-compactor in earlier editions.