Then I'd reinstall that OEM version of XP using the Product Key on sticker.
Do you have the packaging with COA sticker for Win7, because it they had installed a bootleg copy it could well be interfering. The only way to know for sure if this is the case is to wipe the HD with Diskpart Clean Command
, so you'd need to know you have Genuine Windows 7 to reinstall.
Are you booting XP CD to install? The reason I ask is because you said you have the XP Setup files on your fourth partition. You should install from booted CD. Is this a known-good XP CD which is clean and unscratched.