I had the very same problem, and after a while struggling with all those tools like HDAT2, MHDD, and others, wondering whether it was a BIOS or chipset or other problem, I eventually found a solution.
Hardware is fine, since the 250GB on the Western Digital can be recognized by HDAT2, just not modified permanently.
Go to the Western Digital website (http://support.wdc.com/download/?cxml=n&pid=14&swid=53
) and download the Data Lifeguard Tools 11.2 for DOS (CD)
Burn the CD and start with it. Then you can use the software to partition your drive (of course it will erase all data). I created three partitions with 65, 70, and around 115 GB (in case later on only the first 137 GB would be recognized, I wondered whether I would end up with the first two partitions. Then reboot and use your recovery CDs to install XP. It will install in the first partition, and everything will be fine!
The software will install something called Kroll Ontrack Dynamic Disc Overlay which may appear during boot up.
Hope it works for you and everybody else just as fine!