Microsoft delivers the answer to this question with Image Diff Applier. Steffen Schreier, Program Manager for Embedded Windows described on the Windows XP Embedded Team a method to upgrade from Windows XP Service Pack 1 to Windows XP Service Pack 2 or even the Feature Pack 2007 Second Community Tech Preview.

Image Diff enables the creation of a single package of security updates and hotfixes, configuration changes and third-party application updates implemented in the operating system. Moreover, Image Diff enables the comparison of two different images, provided that their format is readable offline. The comparison results in a folder comprising a selection of the resources that differentiate the images. Packaging the resulting folder with the Image Diff Applier will provide the update.

Schreier even describes the basic end-to-end process to upgrade your image to Feature Pack 2007:

1. Store your existing Windows XP Embedded with SP2-based device image in a readable offline format that is accessible from the development machine.
2. Upgrade the SP2 component database to FP2007 and of course, do not forget to back-up your database.
3. Upgrade the SP2 configuration (.slx) file to FP2007.
4. Build and deploy the FP 2007 image.
5. Boot and test the image on a sample device. Rebuild as needed until it works and is configured properly.
6. Store the image in a readable offline format that is accessible from the development machine.
7. Run Image Diff (IDIFF.EXE) against the original SP2 image and the new FP2007 image. The resources that are different between the two images are collected into a folder.
8. Package the diff folder along with the Image Diff Applier (IDA.EXE) so that it can be deployed and applied.
9. Test the package on a sample device.
10. Test the upgraded device for compliance and parity with the original FP 2007 image.