Compressed software

If you have enough room on the drive, you can use the compression utilty (DriveSpace 3?) to uncompress the drive. If neccessary, you might need to delete unused files/programs to free the space.
backing up files to another medium is also a suggestion.

Try the simple approach first.
Boot from a W98 boot disk, and attempt to re-install W98.
Be sure to select custom, and verify that disk compression tools are installed.

Unless you have a lot of software installed, I would recommend a clean install of 98.

You do not need to wipe the entire drive to do this.
You only need to clear out the system files in the root directory, and the Windows files in the Windows directory and it's subs. Primarily the Windows, system and system32 folders.You can leave most of the other folders in the Windows folder alone.

I do this by adding the drive as a slave in a working system so that I can access the files easily. This also, is an easy way to backup critical files.

If your copy of 98 isthe upgrade, you need a boot disk, and your 95 cd to install the OS after deleteing the Windows files off of the drive.
You can download the boot disk files from www.bootdisk.com
When you install 98, select custom, and verify that disk compressionis checked in system tools, so you can recover any compressed files still on the drive.

Even though your application software is still on the drive, the files won't be registered. So you will need to re-install the software.