This doesn’t have to be this complicated… (from my posting last year at parallels mac forum):

(0) For Mac users, at least, realize this all is a bit lame. While you might expect that you could simply use Parallels ImageTool.app to expand your virtual disk image, Win XP will not recognize this expansion automatically. (The absence of this information in the Parallels User Guide fosters this expectation.) Once the image has been expanded with ImageTool.app, Win XP *must* be told to extend it.

(1) Duplicate your Parallels virtual disk image file using the host operating system. On a Mac use the Finder; the location of the file is visible in the Parallels VM property page for you virtual WinXp machine in the “Hard Disk 1″ resources section. Use Parallels’ ImageTool.app to expand the original as desired.

The duplicate isn’t just for a backup. Without using a live CD to boot the virtual machine (as mentioned elsewhere in this thread), you will need to boot into Win XP from a volume that is *not* being extended. Thus:

(2) Using the Parallels VM property editor, add a new hard disk to the virtual machine. This hard disk should use the duplicate disk image created in (1). It will (initially, at least) be known by the resource name “Hard Disk 2″.

(3) Arrange for Parallels to boot off the duplicate. I think this must be done by changing the “Connect to” setting in the “Advanced” tab of the “Hard Disk 2″ in the Parallels property editor to “IDE 0:0″. You will be asked if it is OK to swap; say yes. (Perhaps there is a less hacky way of changing the volume from which the virtual machine boots, but I wasn’t able to find it.) Note that this has the side effect of changing the names of the resources: “Hard Disk 1″ becomes “Hard Disk 2″ and visa versa.

This step is necessary because, it seems, the Win XP’s DISKPART is unable to extend the drive from which the virtual machine system is booted. Unfortunately, DISKPART does not give such an explicit error message but instead a general one, perhaps the same one that people are seeing when they attempt to extend a FAT32 volume. This may be the source of some confusion in this thread.

(4) Now start the virtual machine. Once the system is booted, it may say that new hardware detected suggests rebooting. I’m not sure if it is necessary, but go ahead and reboot.

(5) Once rebooted, from the Start menu use “Run” and type “DISKPART”. In the resulting window type “list volume” (not “list volume*s*”, DISKPART is fussy). Under the specifics described here, the volume to extend should appear as “Volume 2″, letter “E”, I think. This is a bit dicey, though, since the volume you booted from looks in all other ways identical to the volume you want to extend. Then type “select volume 2″, and then “extend”.

(6) Shutdown Win XP and clean up the mess made in (3), (2) and (1). In the Parallels VM property editor, set “Hard Disk 2″ (remember the names swapped in (3)) to “IDE 0:0″. Remove what then becomes known has “Hard Disk 2″. Finally, if desired, delete the duplicate made in (1).

(7) When you restart your VM, it may again say that new hardware detected suggests rebooting. Again, while maybe not necessary, go ahead and reboot. Once rebooted you should see the Win XP now realizes that you disk is larger.