This is a known limitation of the Windows Home Server bare metal restore process. It's a result of the way Windows Home Server backup & restore work, combined with the way NTFS works.
There really is no good workaround. You can sometimes get a backup to restore to a slightly smaller drive, though you will typically not get it to restore to a drive that's 1/2 the size. My recommendation would be to replace the failing drive with one that's the same size or larger.
I'm not on the WHS team, I just post a lot. :)