But I can't see why the E: drive should be a problem. Then again, I've had "phantom" problems installing MS software, and certain drivers, similar to your issue.
Make sure your full path E:\FILES\SETUP\SETUP.INI is correct. Navigate to that directory in Explorer, and make sure that SETUP.INI is there.
Question: For your SP3, is the file you downloaded a .CAB file, or did you just get something like SETUP.EXE? The CABinet file contains the update, while SETUP.exe is just a setup engine, and it is probably trying to download files from microsoft, and can't find them.
If you have or had the .CAB file, are there a bunch of other files in the directory E:\FILES\SETUP\ where the SETUP.INI is supposed to be? If not, you may need to point the setup program to your user account TEMP folder, if the files are in there. You can type %temp% in the Run box to find this folder quickly.
You can check this page:
http://support.microsoft.com/kb/286396
which was for an earlier version of Office, but may be of some help.
Some sightly more "drastic" measures. Post back with results of the above first:
If you can, re-install the Service Pack 2 for XP. It will fix any problems with the Microsoft Installer.
One last thing for now, you can search your computer (all drives) for OHotfix*.log
(with the asterisk). You can copy the text of the files and paste them into a post. Do it in 2 posts if it is easier for you.
Microsoft also has forums for Office at their site, if you'd feel more comfortable there. It would also potentially mean "more eyes" on the problem. Post there also if you wish, but I'll work on this all the same.
Hope we can get this working for you. :)