I was having problems with upgrading an existing virtual machine's Parallels Tools to Parallels 3.0 -- the process would simply hang. When I looked in My Computer, I noticed that the CD-ROM device was not shown at all. When I right-clicked on My Computer and selected Properties » Hardware » Device Manager, I saw the Virtual CD-ROM listed with an exclamation point, i.e. malfunctioning. I tried to update the driver, but that failed.
What worked was to simply delete the CD-ROM device inside the Device Manager, then reboot the virtual machine. When it came back up, the Parallels Tools started installing automatically,
[robg adds: Another possible fix is listed in this hint.]
Mac OS X Hints
http://hints.macworld.com/article.php?story=20070612161246877