One limitation of Parallels Desktop 3.0 is that you can no longer resize a disk image (although Parallels says that will be fixed in an update to be released soon). If you need to resize a hard drive now, I found a good work-around for Windows XP: Acronis True Image Home.
The free trial copy will work nicely. First thing you have to do is add a new hard drive to your virtual machine of the desired size. After you install True Image go to Manage Hard Drives and Clone your existing hard drive to the new one. You can simply use the automatic operation. It will then ask you to reboot and it will boot right into their cloning utility, which took about 5 minutes to clone a 7GB hard drive with about 4GB of data on my MacBook Pro. After it finishes, it will shut down the machine. At this point, go to the VM configuration, remove your old hard drive, and change the connection for the new drive to IDE 0:0. When you start up, the Acronis tool will run once again to finish setting up the new drive and will finally reboot into Windows. You can then remove True Image.