According to Halohalo, "you need to set compatibility mode." If by this he means set FF7.exe to run in Windows 95 or 98 compatibility mode, I don't think its really necessary. First, it works fine for me in Windows XP without compatibility mode turned on, and secondly, compatibility mode seems to break its ability to use controllers (at least USB ones), which I think may be your problem.
Also, make sure that the controller you want to use is set as the primary controller in "Advanced" in the Game Controllers control panel.