I'm assuming when you got it setup that you got an all green when you clicked on Update Settings. When you tried impersonation and got the error did you verify that the account had permission to that file. I've found in the past that even when I've reset permissions on a directory and checked that I wanted all subdirectories and files to have their permissions changed that it hasn't gone through. It's rare but I've seen it happen.

Now, I only quoted the above from your post to ask a quick question. How long are your passwords? By default DNN has the minimum password length set to 7 in the web.config. On manual logins if the password isn't at least 7 characters long it'll fail so if your password is less than 7 you need to change the password length in your web.config. However that doesn't affect automatic logins.

The user that access the database is the user account that you used in the connection strings and has nothing to do with impersonation. All impersonation does is replace the account that DNN runs under (by default it's NETWORK SERVICE which is a local account on the server). The only other thing I can think of doing is testing the connection to the domain's Active Directory from the server using a program like Softerra's LDAP Browser (http://www.ldapbrowser.com)  though with you getting all greens that shouldn't be necessary.