There should be some indication of which disk it's talking about (e.g. an icon). At any rate, from what you've said, it is most likely referring to the CD (never mind the fact you can't write to a CD). If you're already booted off the HD, it would not be referring to the HD. In any event, however, you should just hit cancel.
Also, are you sure this is a CD and not a DVD? Some of the newer Mac's ship with the OS on DVD.
Even if it didn't think the disk was unreadable, it still might not work for you as many of the CD's/DVD's are not interchangeable between machines.