* I FOUND THE CAUSE AND SOLUTION! *
Short answer: Parallels can only remove unallocated space from the end of the drive. Shrink the volume in Windows first, make sure the free space is at the end of the drive (no extra partitions are at the end), then you can reduce the VM disk size. Below is my original reply, adding information as I tested:
I have the same issue as Matthew, and I'm sad that 3 pages later, there was no answer, not even a "We know it's broken, sorry." VM setting's General tab says Total size 40.1 GB; .PVM file is 43.1 GB. In the Hardware tab, Hard Disk shows Disk capacity 256 GB; clicking Properties also shows Size: 256 GB, Expanding disk is checked, Split the disk image into 2GB files is unchecked. Attempting to reduce the size (say 64 GB or 128 GB) and clicking Apply gives a warning that resizing is bad if you lose power. I click Continue, a progress bar shows 100% immediately, then the slider jumps from 64/128 GB back up to 256 GB.
I tried shrinking the Windows volume inside Windows 10 (I reduced it from 261144 MB to 64536 MB in 32768 MB chunks, (larger shrink values returned an error that there wasn't enough disk space available to complete the request), then shutting down and shrinking the VM disk capacity, and it STILL didn't reduce (possibly because Windows somehow has 4 partitions on the VM: 100 MB OEM, 100 MB EFI, the main NTFS one that I just shrank, the free space I just created, and then a 468 MB OEM partition. If that didn't exist or could be moved, and the Unallocated space was at the end, then perhaps Parallels could reduce the reported size.
(Note to others, this might be a possible workaround - at least now Windows won't think there's 256 GB of free space (which is more than I even have free on the host Mac machine), and it therefore won't use up all the Mac's space with an expanding PVM file.)
I then installed AOMEI Partition Assistant (freeware) in the Windows VM, and moved the 2nd OEM partition (changed free space before/after from 192/0 GB to 0/192 GB) to move the free space to the end of the drive. I then shut down and try reducing VM disk size again; this time it took a couple seconds to complete, and kept the smaller size! (If you can't install extra software, the other option would be to delete the trailing OEM partition if you're sure it's not needed.)
Click to expand...