When Protect ISP is turned on, Flash Magic will erase all the way up to the start of the bootloader, which begins at 1E00H. Your code should still fit.
If you turn Protect ISP off, then when you perform the erase you also erase the bootloader. Flash Magic appears to stop because it is stuck waiting for the response from the erase command - a response which will never arrive.
No, you cannot program the full 8k of the device when using ISP. The top part of memory is always used for the bootloader.
If you are going to program the device in a parallel programmer only, then you can erase the whole 8k and program the whole 8k. ISP will no longer work.