Some of the space may be reserved for System Restore, which is why you see a difference between the amount of space physically available and the amount allowed for installing your database. You could try to decrease the amount of reserved space, but if you're already running that low on space, you're better off adding disk space or deleting things you don't need.
Since you mentioned you are administering Windows Servers and it's not your primary job function, you should buy a new disk rather than spending unnecessary time on non-development tasks.
In the meantime, while you're waiting for the new disk to arrive, your best shot at freeing up disk space is uninstalling any unnecessary applications or services. The rest of your disk space is probably used for storing data stores for various services (such as e-mail), or other users' data.
Defragmenting your hard disk will not be effective with so little space, and it won't free up any space, anyway. The built-in Windows defrag utility recommends having at least 15% of your hard drive free. Other defrag utilities can work with less free space, but they still won't solve your low disk space problem.
Try emptying your browser caches and shrinking the browser cache size. With broadband, it's not as important to cache web pages any more. In some browsers, it's set as a percentage of your hard drive--the bigger your hard drive, the more space you're wasting on browser cache. You can type in a fixed amount (say, 50 or 100 MB) and it will adjust the percentage to match.
Empty out your temp folders. CCleaner can help with this (and also with clearing the browser caches, but it won't let you adjust the browser cache size).
Finally, use WinDirStat to find any large files or directories which you can remove from the hard drive. If users' directories are on the server, you should double-check whether any large files are needed before deleting other people's stuff. If necessary, you can set up filesystem quotas.