If you do this at a command prompt, do you see a list of directories?
Code:
$> echo %INCLUDE%
C:\PROGRA~1\MICROS~3\VC98\ATL\INCLUDE;C:\PROGRA~1\MICROS~3\VC98\INCLUDE;C:\PROGR
A~1\MICROS~3\VC98\MFC\INCLUDE;C:\Program Files\Microsoft Visual Studio\VC98\atl\
include;C:\Program Files\Microsoft Visual Studio\VC98\mfc\include;C:\Program Fil
es\Microsoft Visual Studio\VC98\include
$> echo %LIB%
C:\PROGRA~1\MICROS~3\VC98\LIB;C:\PROGRA~1\MICROS~3\VC98\MFC\LIB;C:\Program Files
\Microsoft Visual Studio\VC98\mfc\lib;C:\Program Files\Microsoft Visual Studio\V
C98\lib
Using explorer, do those directories exist?
Is windows.h in one of those directories?
Have you restarted windows/restarted Visual studio since installing the PSDK ?