With Home windows SDK 7, we are able to use Virtual Disk API to produce VHD image files but exactly how should we format this picture files (e.g FAT32 format), assign drive letter and copy some files in it? I could'n use whatever formatting function within the API?

You will have to mount the disk, partition it and format it. You need to have the ability to do that with the home windows WMI interface,

http://msdn.microsoft.com/en-us/library/windows/desktop/aa394572(v=VS.85).aspx

Attach it through the AttachVirtualDisk function, i quickly assume you can easily format it as being an ordinary drive.

You can either use WMI (Format method of the Win32_Volume Class) or even the SHFormatDrive function to format it.