Not a VMWare issue. You cannot upgrade XP to Win 7, only Vista (per MS). You'll have to do a clean install. I had no luck with a manual install. Create a new VM, and use the EZ Install option instead.
Frankly, I wouldn't ever upgrade a microsoft OS anyway - causes no end of headaches. I'd also avoid RC1, since I believe that you can't upgrade that to the RTM version either, and will be stuck with a dead VM when it times out.