Even though I created the image file in the directory that is supposed to be allowed by selinux - it failed and was disallowed by selinux. /var/lib/xen/images

Disabling selinux resulted in a successful guest install to a file under /var/lib/xen/images

selinux now warns me when it would have blocked an action. I wish it had warned every time it was blocking an action. No doubt it is supposed to.