Hi

You may like to think about an imaging program:

http://www.powerquest.com/driveimage/

Yes.  I am able to recreate your problem when I follow the steps
you have given.  And to be exact, the following dialog box appears
with the following caution:

CD Writing

The destination folder is a subfolder of the source folder.

However, I was unable to find any documentation from Microsoft
about this exact problem.  But from the information I found I think
I know why the problem occurs.  It is because when you send files
to be written to a CD-R(W) disk, they are first copied as
temporary files to the following folder:

%USERPROFILE%\Local Settings\Application Data\Microsoft\CD Burning

And since you are trying to copy the %USERPROFILE% folder,
the destination folder *is* actually a subfolder of the source folder.
Of course in this context "destination folder" means the temporary
staging folder named CD Burning [not your CD-R(W)].

To workaround the problem I see these solutions.

-- The first workaround is to use the Backup Utility to backup the
%USERPROFILE% folder to a folder on your hard drive.  Then
burn this backup file to your CD-R(W) disk.

If your operating system is Windows XP Professional then the
Backup Utility (ntbackup.exe) is installed by default.  For more
information about how to "back up files to a file or a tape" search
the Windows XP Professional Help and Support Center for the
words in double-quotes and read the Suggested Topic by that
title (and Related Topics, if necessary).

Note that the Windows XP CD recording program does not
support packet writing and does not contain a feature to format a
recordable CD.  As such, you will not be able to select a CD-R(W)
as Backup destination when using the Windows Backup program.  
[That is why I stated above, "backup the %USERPROFILE%
folder to a folder on your hard drive".]

For more information see the following Microsoft Knowledge
Base articles:

KB279157 - Description of CD-ROM Recording in Windows XP
http://support.microsoft.com/default.aspx?Product=winxp&scid=kb;en-us;279157

KB315255 - Windows Backup Does Not Back Up to CD-R,
CD-RW, or DVD-R Devices
http://support.microsoft.com/default.aspx?Product=winxp&scid=kb;en-us;315255

If your operating system is Windows XP Home Edition then
the Backup Utility (ntbackup.exe) is not installed by default.  
And you may, or may not, be able to install it.  For more
information see the following Microsoft Knowledge Base
articles:

KB302894 - HOW TO: Install Backup from the CD-ROM in
Windows XP Home Edition
http://support.microsoft.com/default.aspx?Product=winxp&scid=kb;en-us;302894

KB311246 - VALUEADD and SUPPORT Folders Are
Not Included on OEM CD-ROMs
http://support.microsoft.com/default.aspx?Product=winxp&scid=kb;en-us;311246

-- The second workaround is to move the CD Burning folder to
a partition folder that you created by performing the steps in
following Microsoft Knowledge Base article. Note that moving
the temporary files location requires unpartitioned disk space,
and Windows must be installed on an NTFS partition:

KB308572 - How to Move the Temporary Files Location
for Windows XP CD Recording
http://support.microsoft.com/default.aspx?Product=winxp&scid=kb;en-us;308572

--  And the third workaround is to copy individual user profile
folders to another folder (not the entire %USERPROFILE%
folder), after logging on as another user (with Administrative
privileges).  And then burning these folders to your CD-R(W) disk.

Unfortunately, even though it sounds like a good idea, you will not
be able to logon to Windows, then copy the entire
%USERPROFILE% folder to another folder, and then copy
that copy of the folder to your CD-RW.  

This is because when you logon to your user account some
hidden and system files in your %USERPROFILE% folder
(such as NTUSER.DAT) are opened by system processes.  
And since they are "being used...", and cannot be "closed",
you will get and "Error Copying File or Folder" if you try to
copy them.