Windows – Allocate free space to “C” Drive

What probably happened is that the defrag operation forced Windows to throw out some system restore snapshots. It'd be a pathological case of fragmentation to cause metadata overhead to be a full 10% of your drive space on top of what Windows normally uses. even then, I'm not sure it's possible.

I don't see anything in Defraggler's version history or documentation that indicates that it's able to correctly defragment files to prevent the purging of shadow copies. In fact, this thread from Defraggler's support forum indicates that they know that it's happening (there's a post from a board admin labeled "Official Piriform Bug Fixer" in thread) but don't indicate whether or not they're going to fix it.

Shadow copies may be lost when you defragment a volume: The reason this happens is that by default, VSS operates with 16 KB clusters by default, while most NTFS volumes are formatted with 4 KB clusters. So if a defrag operation is moving data that isn't a multiple of a 16 KB cluster (or the "distance" it's moved isn't a multiple of 16 KB), then VSS will track it as a change and might purge all your snapshots.

MSDN: Defragmenting Files:

When possible, move data in blocks aligned relative to each other in 16-kilobyte (KB) increments. This reduces copy-on-write overhead when shadow copies are enabled, because shadow copy space is increased and performance is reduced when the following conditions occur:

• The move request block size is less than or equal to 16 KB.
• The move delta is not in increments of 16 KB.

Vista's built in defrag doesn't do this:

One change that’s not obvious to users is our shadow copy optimization during defragmentation. Defrag has special heuristics to move file blocks in a way that will minimize the copy-on-write activity and shadow copy storage area consumption. Without this optimization, the defragmentation process would accelerate the deletion of older shadow copies.

The story is pretty simple. Windows 7 Ultimate is about 10GB. If you have any backups, hibernation enabled, or pretty much anything, you won't have much space left. The only thing to do is get a bigger drive.

Sorry.

EDIT: To address the comment of the OP, if they are different physical drives, I would just install windows 7 on the largest one (if this will be your primary OS, else at least on something with about 50GB or so of free space).
If there is really only one drive, but it is partitioned, you can add space to your partition with drive management (just search for in the box on the pearl menu).