I have all kinds of phone storage but I don't think that's the issue here. I think it's a cache problem. My /cache currently says 59 MB used, 125 MB left.
My theory is that not only does the update file reside there, but I'm guessing that since it's an update, certain OS files are being temporarily cached in case there's a problem with the update. So you may actually need much more space than whatever the file size itself requires.
If anyone having space (to install) problems could download the app "OS Monitor", it may be helpful to get a finger on this. Open the app, and press the "Misc" tab. It'll list your current usage for /system, /data, /sdcard, and /cache.
I think you're right!
/system 97.2% Used
Total: 253,953K
Used: 246,908K
Available 7.044K
/data 20.1% Used
Total: 765.992K
Used: 153,700K
Available: 612,292K
/sdcard 14% Used
Total: 15,654,912K
Used: 2,190,656K
Available: 13,464,256K
/cache 13.4% Used
Total: 192,232K
Used: 25,720K
Available: 166,512K
good luck ...