As far as I can remember, I always placed the update.zip file on the external sdcard (root directory), not the 'internal' which is the 8GB nand flash memory of the device.
The device 'sees' the update.zip file on the (external) sdcard and ask whether I should allow it to perform the update. If I respond 'yes', it reboots, and after a while the android image for recovery mode is displayed (android robot fallen with a triangle including a '!' on top) and seems to remain there until I reboot/reset it pressing the corresponding (power) button.
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