If you create a new Setup project in VS2008 for a project targeting Framework 2.0 it will prompt the user to install Framework 3.5 even if it is not needed.
To fix this right-click on the Setup project in the solution explorer, select View, Launch Conditions. Right-click on the ".Net Framework" item, select Properties Window, then select your appropriate framework version (e.g. 2.0.50727)
Next time you build the solution the MSI will require only the appropriate Framework.