iTunes places the backup files in the following places:
- Mac: ~/Library/Application Support/MobileSync/Backup/
- Windows XP: \Documents and Settings\(username)\Application Data\Apple Computer\MobileSync\Backup\
- Windows Vista and Windows 7: \Users\(username)\AppData\Roaming\Apple Computer\MobileSync\Backup\
You will have to turn on "Show all Hidden Files & Folders" to see them. Close iTunes. Navigate to that folder & delete everything in the folder, but not the folder itself. Re-boot your computer. Try again.