More details are needed actually I think.. Here are some ideas to check though.
From what I can tell though I'll give you some thoughts to look into. I'm going to mention some obvious stuff also, do not take it personally, just lacking info I guess.
Most obvious. Have you actually installed SQL server or are you assming it's installed with DNN?
Have you put a blank database named DotNetNuke into your SQL install?
Is your SQL server configured for integrated security or the other....blanking right now...but plain ID and password non integrated?
I"m assuming, from what I see, you haven't done much beyond installing SQL Server, and plopping DNN into IIS.
So, here is what I recommend to make your life easier.
Download this: SQLServer2005_SSMSEE.msi from Microsoft's Website. this is a mangement tool to help you "visualize" Sql Server. Rather than trying to do everything command line.
Log into your local SQL server install with this tool....this way you can tell if it's actually working also. When you open SQL Managment Studio Express, you will HAVE to log in, and if your database is configured(the default SQL install) and working, it'll usually just put your SQL server in the drop down and ask you integrated or not login. Try em both there...see what happens, and figure out which one works :->
If you log in, and dont' see a database called DotNetNuke, then make one....and remember the name you gave it, the name used on the login screen that it shows for a server, things like that.
If that doesn't work, SQL installs a default utility also, called SQL Server Configuration Manager. This is differetn than managment studio express. Config manager lets you pick what "protocols" people can connect to your SQL with. Named pipes is what DNN uses. So make sure that thing is on in the Config tool, and restart your services.
I"m not sure, how these settings on the page your looking at for database setup relate to the web.config file. I know I put mine in manually in the web.config....but I'm assuming the page you are using from the installer sets it to the web.config...I may be wrong on that...
Anyhow thats a start...beyond that, dunno what else to tell you, other than.....if you have SQL installed, and it's a local copy(IE non production)...just select "automatic" for install method, and it'll use the local copy int he install folder for a database file..but you still have to have SQL installed FYI.
Let us know what you figure out the problem was so others can learn from your problem also!