Hi, James -
If you were booted to OSX when you attempted to run the OS 9 installer on the disk image, then the System Folder included on that disk image was attempted to be used as Classic (an OS 9 installer for your model will not run in OSX). If that .dmg was a copy of an OS 9 install CD, then the System Folder on it is not usable for Classic, nor as a bootable OS when it is copied to a hard drive.
The System Folder on all OS 9 install CDs (both original Software Install and Software Restore CDs, as well as retail OS 9 Install CDs) will function only when it is used on the original medium. Such a System Folder is non-standard, modified for use from a CD which can not be written to; if it is copied to another volume it will not work.
The solution would be to use the original Software Install CD that came with the Mac, then update that as needed using download updaters; or, obtain a retail OS 9.2.1 Install CD and do a direct install of OS 9.2.1 that way. In order to use any of those isntall disks, you will need to boot the machine to the CD, then run the installer (Mac OS Install).
Note - you will also need to have OS 9 drivers installed on the hard drive, else the hard drive will not be mounted (visible) when the machine is booted to any OS 9, including that on an OS 9 Install CD.
You can still get retail OS 9 Install CDs from sites like this -
http://store.yahoo.com/hardcoremac/index.html
A retail OS 9.1 Install CD will also work, but only if your machine is a Summer (2000) model. Later 500MHz models can only use the retail OS 9.2.1 Install CD.
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If you need OS 9.2.1 solely for use as Classic, and not as a bootable OS, as an alternate you can copy a working OS 9.2.1 System Folder from another machine.