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Go into My Computer and look for the iPod drive letter. Right click on it and select Format....I think this option has been re-worded to something else on Windows Vista/7. It might be called initialize or something to that extent. So select that option instead and choose to format it as FAT32.
Once that's done, launch iTunes and restore the firmware on it.
Sorry but it's not there as an option. Also it is not appearing under "Local Storage" section in device manager. Usually can "intialize" format or set active there for drives that don't appear in my computer. But no go. It's something weird this time, not your typical hard drive issue.
Did you try going to Disk Management also to see if it's listed there? To do this, right click on My Computer and go to Manage. Then click on Disk Management. If it says offline or doesn't have a drive letter assigned, make sure you change it to online and assign it a drive letter. It should show up after that.
Sorry agaib, but that's exactly what I meant to be explaining in my last reply, disk management. It's just named differently now in 7. Thanks though!!
Do you have another computer (perhaps using Windows XP) that you can connect this iPod to and format it to FAT32?
Yeah I'm running dual boot with xp and my win 7 machine and I have a vista laptop, same message on all 3 
Are you sure Windows sees the iPod then? I'm sure the Format option should be available in XP unless there is a problem with some hardware. This shouldn't be the problem, but try reseating the hard drive flex cable and make sure it's seated correctly.
If you have another USB cable for the iPod, try using it to see if you can format it within Windows.
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Just replaced a screenand hdd on 30g ipod. Did fresh install of newest itunes on pc, put ipod into "disk mode" plugged it in and launched itunes. Windows 7 detect the ipod and see it has removable storage space; however itunes gives message that ipod needs to have hard drive formatted in order to be compatible with windows. Click next to format and nothing ever happens, EVER. How can I format to FAT32 without itunes? Or how can I get itunes to restore it correctly?
Thanx for any help!!