Hi all; I have a very similar situation except I am running this on a commercial web server.  I have full access to the sever so any mods can be performed.  Any help certainly appreciated.  I'll paste all of my info in below:

in IIS6 Right Click domain > permissions; have aspnet and networkservice added with full permissions

in IIS6 Right Click domain > properties;
 Directory Security Tab: allow anonymous access
 Home Directory Tag:  check: Script source access
    check: Read
    nochk: Write
    nochk: Directory browsing
    check: Log visits
    check: Index this resource
  Application name: Default Application
  Starting Point  <DotNetNuke>
  Execute permissions:  Scripts Only
  Application Pool: DefaultAppPool
  Configuration Button:
  Options Tab: check: Enable session state 20
    Check: Enable buffering
    Check: Enable parent paths
All other settings default
 Documents Tab: Only Default.aspx page in list

in IIS6 Web Service Extension:  Active Server Pages: Allowed
    ASP.Net v1.1.4322: Allow
    ASP.NET v2.0.80727: Allow
    Frontpage Server Exensions 2002:Allow    

SQL Info: Running SQL 2005 wi Management Studio
I have created a new DB (DNN) and setup in ODBC window in the System DSN. It connects using the standard sa account and password.

web.config information:

 <!-- Connection String for SQL Server 2005 Express
    <add
      name="SiteSqlServer"
      connectionString="Data Source=.\SQLExpress;Integrated Security=True;User Instance=True;AttachDBFilename=|DataDirectory|Database.mdf;"
      providerName="System.Data.SqlClient" />   -->
   <!-- Connection String for SQL Server 2000/2005  -->
    <add
      name="SiteSqlServer"
      connectionString="Server=SERVER;Database=dnn;uid=sa;pwd=pass;"
      providerName="System.Data.SqlClient" />
 
  </connectionStrings>
  <appSettings>
    <add key="SiteSqlServer" value="Server=SERVER;Database=dnn;uid=sa;pwd=;pass" />
    <add key="InstallTemplate" value="DotNetNuke.install.config" />
    <add key="AutoUpgrade" value="false" />
    <add key="UseInstallWizard" value="false" />
    <add key="InstallMemberRole" value="true" />
    <add key="ShowMissingKeys" value="false" />
    <add key="EnableWebFarmSupport" value="false" />
    <add key="EnableCachePersistence" value="false" />
    <add key="HostHeader" value="DotNetNuke Test" />
    <add key="RemoveAngleBrackets" value="false" />
    <add key="PersistentCookieTimeout" value="0" />