Your final post explains it all. The first release of Win XP did NOT support 48-bit LBA, so it was limited to using hard drives up to 128 GB. That is the max it could Partition during the initial install. Once it is installed, Wndows will not allow you to change the boot partition size. (Yes, Partition Magic and a few other utilities can expand for you, provided that the Unallocated Space is adjacent to the existing Partition. But Windows itself won't do it.) The BIOS will tell you the correct disk size, confirming that the hardware and mobo hard disk controller software in BIOS can do the job, but the Operating System is still unable. Now just because you upgrade with a Service Pack AFTER doing the install does not solve the problem. Although that allows the updated Windows to use much larger hard drives, it still cannot change the size of the original Partition you are booting from.
Oh, for those confused about hardware and BIOS upgrades, almost all systems since about 2000 have 48-bit LBA support in BIOS and controller hardware. And for sure, EVERY SATA system - mobo controller and BIOS and hard drive itself - has 48-bit LBA built in. OP's case is a classic example of having all of that, but still missing the OS support.
The right solution is to use a Windows XP Install Disk with 48-bit LBA Support built in. That was acquired with SP1, and maintained thereafter. People with your problem (an original Win XP Install disk with no Service Pack) have four options:
1. Live with it. Install XP to a boot Partition of 128 GB. Then immediately update it to SP3. Then use disk Manager to create a second Partition out of the Unallocated Space left over on your larger HDD (non-bootable since this is a data-only Partition), then Format it using an NTFS File System. It will have its own drive letter name and appear in My Computer to be just another separate drive.
2. Install from original disk, with the size limit. Then buy Partition Magic or look for a free software tool that can do the job, and Expand the boot Partition before creating any other Partitions. (This appears to be the route you took.)
3. Buy a newer version of Win XP with at least SP1 included.
4. Learn how to make a Slipstreamed updated Install Disk from your original-version disk - perfectly legal. Microsoft has explanations, updating files and some tools for this on their websites. There are also good tools and instructions for this on many independent websites. Basically you take your licensed old XP Install Disk and copy it completely to your hard drive, then download and run a bunch of files that update and replace that copy, finally producing on your hard drive a complete image of a new XP Install Disk. Then you burn that disk to a new CDR and use it as your fully-licensed but fully-updated Win XP Install Disk.