this is a common problem people have when trying to to downgrade their OS. Firstly you need to check your HDD type to see if its an IDE or RAID. Depending on the type will determine what you can do when trying to downgrade you OS. One thing people forget about XP is that regardless of what hardware you have, it always needs to be installed to the C drive, so having a partition wont make a difference. Also it sets itself as the default OS and you need to change some settings if you want to dual boot with windows 7.
from what you have said, it tells me that you need to include separate drivers to install as the method you are trying fails when you need to insert the disk. this is what it is trying to do, locate the HDD drivers. This can be solved easily though and all you need to do is make what is called a slip streamed disk which contains both the OS files and SP issue as well as the drivers for you HDD. Once you have these you need a program called nLite, which will allow you to combine both the OS files and your drivers together so when you come to install XP it will have the drivers it needs to complete.
hope this helps and any further problems that you may have then let me know and i can point you in the right direction