If you are working with Web Site porjects, VS 2005 Web Setup Project out-of-the-box is almost useless. The only option is to add content (including source code files).
The recommended solution is to publish web project to create precompiled web application.
Then you can add Procomiled site content to Web Setup Project.
Note that you will see VS warning that precompiled Web Site is not recommended to be added to solution.
When you will build Web Setup Project, the error will be shown
Error 1 This application is already precompiled.
You have to ignore both warning and error to make MSI built.
It is not user friendly process!
If you are working with Web Application Projects(WAP), see ScottGu's Creating Packaged ASP.NET Setup Programs with VS 2005 (thanks to Dave's comment below for pointing to the article).