A quick search showed me i was not alone - even if the destination drive was the same size or bigger, i still got the error. Finally i found the following solution:
No disk that can be used for recovering the system disk can be found
- Boot into the Windows 7 DVD
- Format the destination drive to a single, empty partition (you can do this through the Windows 7 installer 'Advanced options' dialog)
- Select 'repair my computer'
- Open the command prompt
- Type diskpart to start the disk partition tool
- Type select disk=0 to change to the destination drive
- Type detail disk to check the details of the drive and ensure it is the correct one. If not, repeat steps 6 & 7 with a different index until the correct disk details are displayed
- Type clean to reset the disk
- Type exit to exit the diskpart tool
- Select Restore from a system image and follow the wizard
The restore process should now complete successfully. I found the above steps from the accepted answer in this thread.