You have some options, re drive upgrade/replacement. The simplest route would be to get yourself a 2.1G drive and use Norton Ghost to move your current drive contents to the 2.1G. If you go larger than 2.1G and stay w/ Win95 (if it's the original Win95) you'll have to partition out the drive, which will bump your CD-ROM drive letter assignment down, which potentially will confuse some of your programs that need a CD to run.
If you're not opposed to a clean install (i.e. start from scratch), then 98 may be the way to go. I know there are many that believe 98 will be a system hog, compared to 95, but I've installed 98 on a couple of Pentium 166/64MB systems, and it runs much better than I anticipated. If you go 98 you can then enable large disk support, which means you can go w/ drives larger than 2.1G and not have to partition it out, plus you get better drive optimization. Win95 OSR2 will also do this, but at that point you might as well go w/ 98.
If you choose to go the 98/larger disk route, you may still face a limitation in drive size, which will be dictated by your mainboard and BIOS. If that's the case, the limitation will likely be at 8.4G. The best way to determine that is to go to your mainboard manufacturer's site and see if you can glean any info. Also, you could post your board id here and see if anyone has any experience w/ it.