As this issue still exists, I thought I'd add something to RacZo's answer for development purposes. If you're not using the Eclipse plugin or for whatever reason you don't have the source, but just the .apk, you can increase the partition size from the command line using the same option when you launch the emulator:
emulator -avd <emulator name> -partition-size 1024
As far as I know, This option is not documented at developer.android.com, so I thought I'd post it here so people might find this solution.