Hey, I get the same error message.
Here is what I did to fix it:
Copy all the contents of the CD to a directory on the hard drive eg: c:\games\Mortimer\ (Including the hidden files Dsetup16.dll and Dsetup.dll).
Now you can remove the CD.
In the directory you copied the game into right click the file Shell.exe. Choose “Create Shortcut”.
Right click the new shortcut called “Shortcut to Shell.exe” and choose “Properties”.
In the field called "Target:" add (desired username).mrm eg c:\games\Mortimer\shell.exe player1.mrm
Hit OK and now you should be able to run the game using this shortcut. Make sure you have a joystick plugged in or it won’t work (The game displayed a corrupted screen when I didn’t have a joystick plugged in).
This skips the game's Launcher where you create your character, so you have to play as the boy. Also I'm not quite sure what difficulty it defaults to; but it runs.
If you have any old saved games just copy them into the folder and refer the shortcut to them.
If you want to play as the girl and choose your difficulty level you can run the game’s launcher through Virtual PC 2007 (running win 98). Run Mortimer.exe and create your character using the launcher. It won’t run the game but you can copy the character file it creates in C:\MORTIMER\ (on the virtual drive) into the game’s directory (on your real hard drive). Then just refer the shortcut to the .mrm file that was created.
Also I don’t know how necessary this is but Lucasarts has an updated shell.exe in its support section:
I replaced my shell.exe with this file and it works just fine.
I hope this works for everyone!