Microsoft has a well written KB explaining steps you can take when this issue occurs:
I went through each step, running the checksur.exe and sfc.exe tools and downloading the stand alone Service Pack 1 installer. All failed. Next, I tried step 4 attempting to upgrade with the original Windows 7 CD. Note, that the CD image must be the exact same used to install the original OS. Same release flavor, Enterprise, in my case, and same SP level. I thought I'd want to upgrade using the ISO image with SP1 built in, but no that refuses to even attempt an upgrade.
Finally, with the correct ISO image I got the clue that no previous error message had given:
- There is not enough free space on partition (C:). A total of 16372 megabytes (MB) of free disk space is required. Try Disk Cleanup, or moving files to an external location such as a CD, DVD, or external hard drive, and then restart the installation.
I didn't have enough free space on the drive to install the Service Pack. At first I was surprised because I had 10GB free, but in fact Win7 SP1 requires about 16GB to install. Next, I was annoyed that this simple error wasn't raised by Windows Update in the first place.
I keep my drive space pretty sparse on my test VMs because they don't have many applications or data stored on them. But a 40GB primary drive size is not enough for Windows 7. I expanded it to 80GB using VMWare Workstation 8's built-in "Expand Disk" tools then used sysresccd and gparted to expand the NTFS partition across the whole disk.
Success! Windows Update installs Service Pack 1 with no problems. I hope this helps you or someone else avoid a half-day of IT induced profanity.