Is it possible to upgrade from a software RAID-1 to a RAID-5 under Windows 2k3 Server? My Google searches didn't really turn up anything definitive here.
Most of the time, no. You must backup the RAID-1, destroy the RAID-1, rebuild as RAID-5, then restore.
Under some hardware-raid it is possible to grow RAID arrays but under software raid it rarely is.
The standard and painful way: backup your data, recreate the array, load the data.
Optionally, if the system allows this: disconnect one drive from RAID1 putting it into degraded mode, create RAID5 in degraded mode (with one disk missing). Copy over the data, delete RAID1 and add the missing drive to RAID5. This, however, usually takes longer than using an external backup.
If you already have to back up the data to restore it to the new RAID-5, during the downtime you should look at installing a hardware-based RAID solution. If your server is hitting the disks hard (which I assume it is, since you're adding more drives), the software-based RAID will put a hurtin' on your CPU usage. I'd put serious thought into a RAID controller with a built-in XOR processor, to take the storage processing off of the CPU.
Hardware RAID sometimes makes allowances for this. But the software RAID in Win2k3 has no allowance for it that I'm aware of.
The "add mirror" function does what it says - adds a volume member to a mirror for a RAID 1 setup. When you set up a RAID 5 stripe, you'll need to specify at least 3 volumes concurrently to begin the process because you can't have a two-drive parity stripe (a drive failure would result in half your data missing because the parity stripe would occupy the blocks needed on the remaining drive). At that point you're effectively functioning as a mirror anyways.
RAID 5 will gain you space, you'll loose some performance, and your protection against disk failure just shrank a little bit. If you can afford it, RAID 10 with 4 drives usually will beat out RAID 5, although the loss of extra space and/or costs for extra disks can be prohibitive under certain circumstances. You'll loose the space of a single drive, but you'll gain much-improved read performance, and a bit more redundancy against multi-drive failures (you can have two drives fail and the array will continue, as long as the failures are not on the same part of the mirrored stripe). And with the right setup, using per-drive controllers, you can mitigate any write performance losses.
The real question I think is "Do you really want to?"
You say that you need more space for files on a server that isn't under heavy load, yet the entire reason for having RAID 1 with a hot spare is for absolute reliability of your data (although the performance is pretty good too). If this is no longer important, then go for it.
I'm also assuming that you have a hot spare in the first place, since you would need a minimum of 3 disks for RAID 5. 9 times out of 10 however, it's totally worth whatever money you would spend to just get some bigger disks.
My guess however, is that this is your home media server, because if it were a publicly available server that needed to be very reliable, then you would care about things like a hardware RAID controller. Software RAID isn't anywhere near as reliable, and RAID cards these days are not expensive. (ref: Highpoint RocketRAID) Even if this were a NFS or SMB share on an office network, there would be no problem backing up the data to another computer, nuking the array, and rebuilding it as whatever you want.