I should have mentioned that I have 2 RAID arrays (on both Mainboard controllers) configured. After reading around forums some more, I finally came across an answer that worked:

Disconnect ALL drives (USB, HDD, card-readers, etc.) before starting the installation.

Apparently in my case, the 2nd set of (RAID) drives was messing with Windows Setup. I just unplugged the SATA cables from the drives and installation worked without any errors.

Update:
After the installation was almost finished I was asked for my license key, which I inputted but Windows rejected. I found out that I because I formatted the main XP partition, the installer was unable to find a previous XP installation. Couldn't they just ask for the original XP CD and key? :(

Lesson learned? If you are upgrading from XP to 7 using the Upgrade DVD, don't format your XP drive! Windows 7 will rename your old Windows for you. Just make sure to use the Windows Easy Transfer tool to backup users first.

I had to re-install XP, which was even more difficult as I had to load the NV-RAID drivers onto floppy using the special MAKEDISK.exe tool. Then, because I formatted the 1st and 2nd partitions, the 3rd partition became partition #1 -> C: which after the 1st reboot (during install) I got some error about not finding the boot drive (not NTLDR, the other one ;). I then proceeded to back everything up to a USB drive using Ubuntu-on-a-stick which took forever (4+ hours). Afterwards I was able to delete all partitions and create a new one as the first. **phew**