Where/When does this error occur? Can you post a screen shot? Does your virtual machine hardware configuration include a CD/DVD device?
How did you get to the "Select the driver to be installed" window in the Windows 7 installer? Are you not using the Parallels Desktop new virtual machine feature that automatically installs Windows 7 for you? Parallels Desktop -> New... -> Choose an image file..., select the Windows 7 iso, Continue -> Express installation, enter Windows 7 product key, Continue -> Like a PC, Continue -> Customize settings before installation (if you want to set the virtual hard disk size, etc). Then start up the virtual machine.
I was trying to install the 64bit version on Parallels Desktop 5. I installed the 86x version with no problems. I guess version 5 doesn't support 64bit.
Parallels has supported Windows 7 since Parallels Desktop 4. http://kb.parallels.com/en/6826 http://kb.parallels.com/en/6854 The instructions I gave where for Parallels Desktop 6. I think Parallels Desktop 5 is similar. Are you using the latest version (5.0.9376)? http://kb.parallels.com/en/5802 Maybe if you explain exactly how you tried to use the iso or create the new VM, someone can compare your steps to see where things go different.
I had the same issue with an Win 7 ultimate .iso file downloaded from the Microsoft store. Loaded the image and then coming up with the message CD/DVD driver missing. It turned out that the downloaded .iso file was not the same size as the image file was supposed to be i.e. 2.2GB versus 2.5GB. I downloaded again and the installation went without problems. Check that the .iso image is the correct size as it maybe corrupt from an improper download.