This was error I have received while trying to convert physical machine running Windows 2003 SP1 into VMWare image.

After some googling around and experimenting (this link was most helpful to point me in correct direction) I found solution that worked for me.

All I had to do was to disable Floppy Drive in the System applet of Control panel. After this, the conversion continued and right now is squeezing 100 GB disk into 50 2 GB files on external USB disk.