---Glad you got it working. Please forgive me if I did not bring ideas for you just in time.
As I told, something similar happened to me, and I solved it by downloading the separate images for system 7.0 in floppies (about 1,3~1,4 mb each), which btw I burned using Diskcopy. How would I get Diskcopy to work in a non-booting Macintosh Classic? Easy: with 608sysst.exe I create a perfectly bootable system 6.08 disk, which allowed me to install and run Disk Copy. So this way I generated the seven physical floppies required to boot-and-install system 7.01 happily.
Regards,
Juan Javier.