If I'm understanding you right, you are trying to get rid of the dialog that pops up telling the user to uninstall the existing version before installing this version.
If thats right, I had a similar problem not to long ago. The solution is simple just increment the version number on your installer and make sure the following properties are set on your Setup project;
- DetectNewerInstalledVersion = true
- RemovePreviousVersions = true
As far as the removing files that are in the directory, like Jack suggested, if you are installing the files and you want them to remain, flag them as Permanent. If the files are created from your app, such as backups or error logs, when you uninstall the application it will leave those files there by default.