Thanks to Oran Dennison for this solution.
Please be awear that Microsoft does not support running the Windows Phone 7 CTP Tools on Windows XP. I found this solution, and I am using it at my own risk, as should you.
Workaround for installing Windows Phone 7 CTP on Windows XP:
1.Download the Windows Phone Developer Tools CTP Refresh from here: developer.windowsphone.com
2.Extract the contents of the setup package by running vm_web.exe /x and choosing a path to extract to
3.Go to the folder you extracted to in step 2 and open the file baseline.dat in notepad
4.Look for the section named [gencomp7788]
5.Change the value InstallOnLHS from 1 to 0
6.Change the value InstallOnWinXP from 1 to 0
7.Save and close baseline.dat
8.Run setup.exe /web from the folder you extracted to in step 2
