I had this problem too, but found a fairly easy fix, at least on windows 7.
A little background first though, I have my OS(win7-64bit) installed on a 40GB SSD, and then everything else including my program files and user folders are on a second, 3TB hard drive. I'm using symbolic links to make this all work well, cause windows has a hard time when it doesn't see the program files and users directory on its install drive, even when you change the registery settings for them. So iTunes incorrectly thought it was trying to backup to my SSD drive due to the symbolic links, when in reality it was trying to back up to my 3TB drive.
The fix is to change the registry settings for the "AppData" folder that itunes backs up into. In windows 7 it is quite simple to do. You don't even have to directly touch the registry. The steps are as follows (for Win7):
1. Navigate to your AppLocal folder. To do this simply open a folder, and type in "applocal" in the location bar and hit enter.
2. There will be three folders. Do the following for all three folders(Local, LocalLow, and Roaming):
1. Right-click and select properties
2. Select the "Locations" tab on the uppper left of the window.
3. Change the location to where you have more disk space. For me it was as simple as just changing the "C:\" portion to "D:\".
4. Click apply. At this point windows will ask you if you want it to copy the data already in the App folder to the new location. If the data isn't already in the new folder you selected, then say yes, or many programs won't work correctly. If, like me, you are using symbolic links and just selected the folder that the orginal pointed to anyway, then you can hit no.
5. If windows had to copy anything, wait for the copy to finish.
3. Restart iTunes if it is still open.
4. Try again to upgrade and it should now backup without complaints.