I am running into the same problem with a WinXPPro guest. When I tried to run the D:\setup\setup.exe it told me the drive was not formatted and would I like to format it....
I had a similar problem. I just mounted the iso image directly, then it worked fine. In the cdrom device setup, select "Use ISO image", and browse to /usr/lib/vmware/isoimages/linux.iso.
HTH,
Joe
