Formating and or running scandisc on the drive should mark the bad clusters as unusable.
I have had this problem with 9X when the RAM was either incompatible with the motherboard/BIOS, or 2 DIMMs were not compatable with each other.
Windows works the RAM harder than the POST test does.
I also had a similar problem with a motherboard with a bad USB controller. So, try scaling back the system to minimum hardware. (hdd, cd, video, floppy)
Once you have a corrupt vxd file, you need to delete the file before you can get windows to boot and re-create the file.
Since you are in the re-install mode, you can either start over again, or seek out and delete the .vxd files (Windows\system\vmm32 is the most likely location of the corrupt vxd)
Also, do you have more than 511MB of RAM?
W9X has known issues with more than 511MB. While this is very configuration dependant, Windows often ignors the first 512MB of RAM when more than 511MB is installed.
Chas