Problem Installing Lion on MacBook2,1 using USB
Thank you all for your help. I finally managed to make it work. It seemed the problem is somehow related to USB boot support of MacBook2,1. This is how it worked for me:

use these 5 steps if you're upgrading from 10.5.X to 10.7.X


Copy /System/Library/CoreServices/SystemVersion.plist to desktop
Open it in an editor (I used TextEdit)
Under ProductVersion change 10.5.X to 10.6.X
Save and Authenticate
copy it back to /System/Library/CoreServices/ overwriting the original SystemVersion.plist




use these 8 steps if you have a problem with USB boot.


Using BootCamp Create a 5GB partition
Open Disk Utility
Select Lion installation file (DMG) and click on Open
From main pane Click on Restore Button
From left pane Drag and drop ESD (below the DMG) onto Source
From left pane Drag and drop the newly create partition onto Destination
Click on Restore button below Destination
Restart and hold Option key. Now the partition is available in the boot menu.