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1. Boot from the Windows 7 or Server 2008 R2 media.
2. Select language options and click Next.
3. At the Install Now screen, press Shift and F10 simultaneously to open a command prompt window. You'll partition the disks and create your VHD file in this window.
4. Select the disk and wipe all of its existing content using the following commands.

   diskpart
   list disk
   select disk 0
   clean

5. Create a 200 MB system partition using the following commands. The Windows 7 and Server 2008 R2 installation procedures normally create this partition automatically.

   create part primary size=200
   format fs=ntfs label="System" quick
   active

6. Create a partition using the rest of the space on the disk. This partition will hold the VHD files. I call the partition Boot, but you can call whatever makes sense for you. Also, I've used the C drive, but when you boot to the VHD the drive letters will shift. If you assign a different letter, make sure to use the new letter in step 7.

   create part primary
   format fs=ntfs label="Boot" quick
   assign letter=C

7. Create a VHD file on the C drive. In this example, I've created it as a 25 GB file that is an expandable disk. You can use "type=fixed" instead of "type=expandable" to create a fixed-size VHD. A fixed-size VHD will use space on the physical disk equal to its full size as soon as the VHD is created but will give better performance, so I recommend fixed-size disks for uses other than testing.

   create vdisk file=c:\win7ult.vhd maximum=25000 type=expandable
   select vdisk file=c:\win7ult.vhd
   attach vdisk
   create partition primary
   format fs=ntfs label="Win7Boot" quick

8. You can now list your volumes with the command

   list vol

   An example list is shown here.

   Click to expand

9. Exit Diskpart and close the command prompt window by entering the "exit" twice.
10. Proceed with the installation. When you're asked to select the installation target, choose the VHD partition you created. The installer will warn that you cannot install it on the partition, but you can ignore the warning.

    Click to expand

Installation will now progress as usual. Once installation is finished, you can see that the VHD partition is now the C drive while the partition containing the VHD files is demoted down to the D drive, as shown here. If you look at the contents of the drives, you'll see D contains the VHD file and C, the content of the VHD, looks like a standard drive with a Windows installation. The 200 MB partition you created doesn't have a drive letter and is essentially invisible to the OS.

Click to expand