I am in about the same situation. I've managed to get C: up to about 1.2Gb free, but it still will not work. I even tried running it from the commandline using the silent switches. It still say that there is not enough space. I hope we get an answer to this one!
-Steve
Heath Stewart has a blog post about VS 2005 SP1 disk space usage.
http://blogs.msdn.com/heaths/archive/2006/10/06/VS-2005-SP1-Requires-a-lot-of-Disk-Space.aspx
Does this help?
Thanks,
Chris