R – .msi Installer for web setup project fails on windows 2008 server with IIS 7

I am trying to install the web setup project on a Windows 2008 server with IIS 7. However, it dies at the first step with the error "The installer was interrupted before could be installed."

I tried installing with logging enabled and the log files have an error message like below.

MsiGetPropertyW – Getting Property 'VSDNETMSG'…
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: Property 'VSDNETMSG' retrieved with value 'This setup requires the .NET Framework version [1]. Please install the .NET Framework and run this setup again.'.
MSI (c) (64!8C) [14:31:45:291]: Creating MSIHANDLE (3) of type 790531 for thread 2188
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: MsiSetPropertyW – Setting Property Value…
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: MsiSetPropertyW – Setting property 'VSDNETMSG' to 'This setup requires the .NET Framework version 3.5. Please install the .NET Framework and run this setup again.'.
MSI (c) (64!8C) [14:31:45:291]: PROPERTY CHANGE: Modifying VSDNETMSG property. Its current value is 'This setup requires the .NET Framework version [1]. Please install the .NET Framework and run this setup again.'. Its new value: 'This setup requires the .NET Framework version 3.5. Please install the .NET Framework and run this setup again.'.
MSI (c) (64!8C) [14:31:45:291]: Closing MSIHANDLE (3) of type 790531 for thread 2188
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: MsiGetPropertyW – Determine size of property 'VSDNETURLMSG'
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: Allocating space…
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: MsiGetPropertyW – Getting Property 'VSDNETURLMSG'…
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: Property 'VSDNETURLMSG' retrieved with value 'This setup requires the .NET Framework version [1]. Please install the .NET Framework and run this setup again. The .NET Framework can be obtained from the web. Would you like to do this now?'.
MSI (c) (64!8C) [14:31:45:291]: Creating MSIHANDLE (4) of type 790531 for thread 2188
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: MsiSetPropertyW – Setting Property Value…
INFO : [11/29/2009 14:31:45:291] [CheckFX ]: MsiSetPropertyW – Setting property 'VSDNETURLMSG' to 'This setup requires the .NET Framework version 3.5. Please install the .NET Framework and run this setup again. The .NET Framework can be obtained from the web. Would you like to do this now?'.
MSI (c) (64!8C) [14:31:45:291]: PROPERTY CHANGE: Modifying VSDNETURLMSG property. Its current value is 'This setup requires the .NET Framework version [1]. Please install the .NET Framework and run this setup again. The .NET Framework can be obtained from the web. Would you like to do this now?'. Its new value: 'This setup requires the .NET Framework version 3.5. Please install the .NET Framework and run this setup again. The .NET Framework can be obtained from the web. Would you like to do this now?'.
MSI (c) (64!8C) [14:31:45:291]: Closing MSIHANDLE (4) of type 790531 for thread 2188

.NET 3.5 is indeed installed on the machine and the app works when I deploy using XCopy.

I have searched the internet for this error and have found that installing the IIS 6 Compatibility resolves the issue. Though, I don't want to install IIS 6 metabase compatibility. I rebuilt the set up with lauch condition as IIS >=7 and in X64 mode. But to no avail.

Could you please help me on this?

Thanks,
Krantz