I have a flash drive which is FAT32 formatted. I want to put a linux filesystem on the drive inside a file. I know I can do this by creating a file and formatting is with ext3 (or any other file system) and then mounting it with the -o loop option. What I would like is that the above filesystem be compressed. Essentially something like a read-write squashfs.
Is there something that exits that I can use? Additional bonus if the file can be stored as sparse, i.e. the file re-sizes as data is written or deleted.