Thank you William,

Yes, issue is the same, but I am not sure this solution works. When I change connection string in config file to look line non-Express SQ Server, I still have to go through the wizard. Wizard doesn't take DotNetNuke name for the database and it doesn't take ful name (C:\DotNetNuke\...) either.

I created a new database in SQL as you suggested and re-installed DNN. It works fine (with the same IIS setings) .

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Boris

I had a backup copy of the file, and web.config is the same.
I was able to make the site work again, however. Not exactly they way I wanted, though. Here is what I did:
Instead of using a separate website in IIS using port 8081, I made it inot an application under default web site using port 80 and pointed it to Default App Pool.
I changed identity of Default Web Pool to be Local System and .Net Framework to be 2.0

All of a sudden it works now. I still think it should work they way it was configured and I am sure all rights were given correctly to Network Service account in the databse and directories and database files. But at least it works and it is good enough for me.

Thanks for trying to help!

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Boris