I've come across the same issue three times in the last two days, so it's bloggin' time!
CardSpace requires that the user's profile is on an NTFS drive. Currently, the problem you see if your profile is on FAT32, is that the CardSpace Identity selector won't come up, and you'll get something in the event log that looks like this:
The description for Event ID ( 102 ) in Source ( Microsoft.InfoCards.Diagnostics 126.96.36.199 ) cannot be found. The local computer may not have the necessary registry information or message DLL files to display messages from a remote computer. You may be able to use the /AUXSOURCE= flag to retrieve this description; see Help and Support for details. The following information is part of the event: The Windows CardSpace service cannot be started on this file system., at System.ServiceModel.Diagnostics.ExceptionUtility.TraceFailFast(String message, EventLogger logger)
at System.ServiceModel.Diagnostics.ExceptionUtility.TraceFailFast(String message)
at Microsoft.InfoCards.Diagnostics.DiagnosticUtility.FailFast(String message)
at Microsoft.InfoCards.Diagnostics.InfoCardTrace.FailFast(String message)
Which, once you know what the issue is, it's easy to guess the reason.
So, why doens't it work on FAT32? CardSpace ACL's the card store so that it's locked down quite tight, and even the user doesn't have access to the files. It's a security precaution to prevent tampering both by snoopy users and snoopy processes.
When CardSpace starts up, it checks the security of the card store, and if it's not appropriate, it refuses to continue.