John - 

You may have hit the same wall I've been dealing with for the past hour, so I'll share....

I'm a total noob at DNN but am an old hand with SQL Server.  Been using it since SQL Srvr 2000.
I've run into a series of frustrating connection issues and am posting this because it might possibly be your problem as well.

I stumbled into this solution messing about with Web matrix.  

The 'sqlsiteconnection' kept erroring out and I could not figure out how to edit it, but finally found that 'database.mdf' is in the App_data subfolder of the My Websites folder in my document library (windows 7).  

Then the lights went on, this isn't using SQL Server Express! I believe it is using (or better stated my guess is it is using) SQL Server compact edition.  Go back to the initial database set up screen and check the LOWER radio button to use SQL Server Express.

Did that, chose my SQL Server Express 2008 R2 instance, and then the database I had already created in it (DNN) and I'm past that and have the database installation complete.  

They really should have called the upper radio button something other than SQLExpress, because (if my assumptions are correct) that is very misleading.  In any event, it solved my connection problems.

Regards

Randy Volters