Hm...
I often use multipartition (sometimes multiboot) systems. Most of the time W2k/XP is on D, E or even once on L partition... never had any problems with updates. Once I made my C partition very small size (20 MB) and it all worked fine.
When I apply SPs on W2k or WinXP it makes temporary folder on partition with biggest free space.
There are also switches that instruct where to unpack the files. but for this one you have to start SP from command prompt.
Also, it would be wise to check out your TEMP and TMP envirement variables.