I came across these tools which can be used to create install CDs for Windows XP and Vista that result in an operating system install using less then 1 GB.

Windows XP: Nlite, nLite - Deployment Tool for the bootable Unattended Windows ...
Windows Vista: Vlite, vLite - Windows Vista configuration tool

As part of the process of building your Windows box you can slipstream in all of the Windows updates that have been released. You will need to download these updates, the tool Windows Update Downloader can do this. Another tool is called HFSLIP.

The web forum MSFN (http://www.msfn.org/) has forums dedicated to these projects.