If its saying that there's not enough hard drive space, clearly that means the hard drive is working, which makes life easier already. By the sound of it, I'm assuming you have a set of system install disks, so try starting up from the Disk Tools floppy disk, if its an original Apple one, ideally it should say the model of Mac (Macintosh LC III) under where it says Disk Tools. (This is important, since if you're using System 7.1, the LCIII needs a special System Enabler file, System Enabler 003 in order to start up). When you start up from Disk Tools, you should see the icon for the hard drive as well as the floppy disk. Go into the hard drive, and check that:
- There is a System Folder present
- The System Folder is "blessed" (that is, it has a little icon of a Compact Mac inside the folder)
- The System Folder contains the following files: System, Finder, System Enabler 003
If any of those files are missing, or if you don't have a System Folder at all, you should be able to copy the one from the Disk Tools disk. If you do have a System Folder, but it is unblessed, so long as it contains all three files mentioned, and they are not corrupted, you should be able to re-bless it by opening and closing the System Folder.
Once you have checked that all this is in order, restart, and hopefully all should be well.