After spending a lot of time trying to get this process (install Windows XP from USB Flash drive) working I found an easier, quicker, solution (compared to most online tutorials). It’s called WinToFlash.
This tutorial shows you how to install Windows XP from a USB Flash drive. (Seriously, easy!) It would probably also work for Windows 2000, Windows Vista, Windows 7, etc.
Optionally you can follow these nLite tutorials to remove unwanted Windows files before installing Windows:
I just finished doing this on my Asus 1001p netbook, after removing Windows 7 Starter (which consumed over 500MB of the 1Gig of memory at bootup, no programs running!)
I decided to opt for installing Windows XP via a USB Flash drive. I didn’t have an external DVD drive available. After following various complicated tutorials (which never did fully work for me) I found a very simple way to take the resulting Windows install files created by nLite (or copied from your Windows install disc) and create a bootable USB Flash drive: WinToFlash ( http://wintoflash.com ).
With WinToFlash all you need to have is a Folder on your PC containing all the Windows install files. Then you just open WinToFlash, tell it where your Windows install files directory is, then tell it what letter your Flash drive is (i.e. J: ). It does the rest for you. SIMPLE 
Once it’s done boot from the flash drive on your netbook (or PC you want to install this copy of Windows on).
When I first tried this I was getting BSOD (blue screen of death) errors when Windows setup was starting. (The problem was not with WinToFlash) After doing some research online I decided it might be due to some corrupt files (the XP disc I copied files from was too scratched up)… so I located another disc and went through the nLite process again (was easy because it saved my previous settings)… then did the WinToFlash process again. This time Windows XP installed without a problem from my USB Flash drive! (much easier than the tutorials that wanted me to accomplish this with 3+ programs and never worked)
The best thing about this is:
- My Windows install was only 270MB (with all Asus 1001p driver integrated and non-essential windows XP stuff removed, thanks to the nLite tutorial)
- Bootup to XP is fast (less than 30 seconds)
- Memory usage is at less than 200 MB even after installing a bunch of programs (disabled non-essential startup processes).
- No CD/DVD drive necessary for installation.