The 4GB file size limit of FAT32 has been an important premise for KNOPPIX (and similar live distros) in the past, and it still is the main reason why contemporary KNOPPIX comes with two cloop-compressed files: The basic KNOPPIX, and the overlay KNOPPIX1. Both sized to fit on a FAT32 file system.
When we remaster, we can easily put everything into one file, but it has gotten increasingly harder to purge enough from the DVD package list to make everything fit within 4GB, when own additions are included.

Experimenting a bit with 7.7.1 DVD remastering, it turns out that while it is fairly easy to purge enough to compress the DVD content into 4GB without any overlay, it is probably not worth it to shoehorn significant added packages into that format.

And still, there are some good reasons to conform to FAT32. The most important is booting. While it is easy to prepare FAT32 media to boot almost everywhere, too often other kinds of media fail to boot somewhere. So for me, it's not worth the effort to do things otherwise. Also, this seems like an easy basis for running in Vmware Workstation virtual machines.

This takes us back to the good old multiple overlays technique, which our friend utu has championed on this forum:

The principle is that the persistent store is cloop-compressed into an overlay as KNOPPIX<n>, n=1,2,3..., put into the KNOPPIX directory and automatically aufs-mounted upon next boot. This isn't something I would recommend to do several times. There is, for example, no file deletion involved, old versions of files are not overwritten, but just superseded by newer versions in the aufs mount. In order to have "real" file deletion, remastering is needed.

But it is possible to make Knoppix into a real power package this way. For example, running on ext3 one could make a 8GB overlay file containing lots of programs, like databases, statistical packages etc. Then compress it into a KNOPPIX1 ca 4GB overlay (assume we have purged and compressed the DVD contents into 4GB KNOPPIX), create 2-4 knoppix-data.img<n> overlay files in addition to knoppix-data.img and stuff everything into a 32 GB USB stick which can be booted "almost everywhere". For my own use, I'm quite sure it will suffice with a ca 2GB overlay. There is, for example, little to be gained by compressing JAVA .jar/.war files, as they are mostly already compressed.

Here is the overlay creation function utu posted:
#utu's overlay creation

MakeOverlay() { # Cloop-compress & save /KNOPPIX-DATA as /mnt-system/KNOPPIX$1
    echo -e "Creating "$ISO"; patience, this may take some time..."
    cd /; sudo mkisofs -x *[Cc]ache* -R -U \
           $ISOSRC | create_compressed_fs -B 131072 -m - - > $ISODIR$ISO
    echo ".done; "$ISO" additions from $ISOSRC saved to "$ISODIR"."