Try doing it via the command prompt. Go to Start -> Execute: cmd -> Enter
Execute the following:
format (Drive letter): /FS:FAT32
You don’t need to use cmd prompt at all sometimes. But the following way might actually take twice as long or not at all as the above example but you could use it if you are uncomfortable using cmd prompt.
Format the disk as NTFS using first. Once this is complete you can then right-click the partition and choose Format. In File System you can then select FAT32 from the drop down.
The reason you can't do it directly is because Windows has this limited through the GUI.
From: http://en.wikipedia.org/wiki/File_Allocation_Table#FAT32
The Windows 2000/XP installation
program and filesystem creation tool
imposes a limitation of 32 GiB [18].
However, both systems can read and
write to FAT32 file systems of any
size. This limitation is by design and
according to Microsoft was imposed
because many tasks on a very large
FAT32 file system become slow and
inefficient.
...
The maximum possible size for a file
on a FAT32 volume is 4 GiB minus 1
byte (232−1 bytes). Video
applications, large databases, and
some other software easily exceed this
limit. Larger files require another
formatting type such as NTFS.