I just spent the weekend dealing with this.
Credit to this Austrian guy diagonalinho who posted this above. I had a little trouble understanding his instructions (looks like English is not his first language) so I am posting the summary that I wrote for another person having the same problem. Credit goes to diagonalinho though.
First, I think someone already mentioned that the reason you are having the problem is because Boot Camp Assistant formatted the XP partition as FAT32. It needs to be NTFS. Windows Setup is supposed to ask you how to format the new partition (see page 13 of the Boot Camp manual). If your experience is like mine, Windows Setup never asks that question. It simply goes from you selecting the C: drive (Boot Camp manual page 11) to the installation process (a blue screen yellow bar marking progress as things are copied to the partition).
Here is a link to the manual that I'm referring to if you don't have it already:
http://manuals.info.apple.com/en/BootCampInstall-Setup.pdf
I do not know why the format step is being skipped in some installs but not in all. Call it an "undocumented feature" (e.g., bug).
Here is how to fix it:
Boot Camp Assistant should have instructed you to insert the XP CD in the drive and then it will restart. This is what you want. After some time, you will get a blue screen with white text in the upper left hand corner that says "Windows Setup." On the bottom of the screen there will be some words telling you this and that is loading. Keep an eye on this. It will slowly list a bunch of things that it is loading. Toward the end, it will say something like "Starting Windows Setup." At this point, press and hold the F10 button. Keep holding it until you get a black screen with white text.
You are now in the Recovery Manager. You will be asked what volume you want. The only choice you should have is 1. This is your new Windows partition, it is not your Mac OS partition. YYou may safely type "1" (without quotes) and press return. Then, the prompt will look like this:
C:\WINDOWS\
At the prompt, you type "cd.." (without quotes) and press return, the prompt will now look like this:
C:\
Now, we are going to reformat your windows partition as NTFS. To do so, at the prompt type the following without quotation marks "format c: /fs:ntfs" When typed into the prompt, it will look like this (pay close attention to spacing)
C:\format c: /fs:ntfs
It will give you a warning and ask if you are sure. Type "y" and press return. It will take some time to format and you will see a percentage counter counting up from 1% to 100%. When it is done, you will be back at the C:\ prompt where you will just type "exit" and press return.
Now, Windows Setup should proceed normally.