It definitely needs ASP.NET 3.5 sp1 or it simply will not function.

 --- BUT having said this - how are you determining that 3.5sp1 is NOT installed.
IIS will not show anything other than 2.0 being available since 3.0 and 3.5 and 3.5sp1 are all really treated like service packs by IIS.
Its only with the jump to 4.0 that the newer versions of IIS actually differentiate.

It does seem very odd that any server would NOT have 3.5sp1 installed it was delivered as part of the standard free windows update packages.

Westa

All sounds way to hard to me - life was meant to be easy - I cant make the point more strongly these days - host with a company that understands the content management system your site depends on.

There are a number of very good DNN hosting companies around who are dedicated to hosting DNN.  When you host with them they expect you will be running dnn and have systems that are set up optimally for DNN.

Many like PowerDNN even ofter to do the port for you from your old host for free as part of the migration process.

Honestly - go check out a few and move - your life will be so much easier - ive seen some as low as 4.95 a month.

Me personally - I prefer to spend a little more from peace of mind $20 a month - its hard to go past www.powerdnn.com
We moved a client last week from their old host with the entire move taking a matter of hours - domain delegations included.

Oh and as an aside - I would avoid cloud hosting with DNN unless you are with a host that understands DNN very well - cloud is a nice buzz word but with complicated application frameworks - unless the cloud and the framework are optimized to work with each other - you can wind up with all sorts of issues.

With regard to your existing host - sounds more like they are in the earn as much as we can for a little work as possible category.  
Bottom line with DNN - it is a highly complex system that has been optimized to operate with the use of the latest microsoft technologies 
You want to be running on a modern server running iis 7 and sql 2008.

As for what can and cant be done - if asp.net 3.5 or 4.0 is installed on a server ALL web hostings on that server would have access to it.
As for all this talk of sp1 and what not ... there seems to be a lot of talk at cross purposes.

ASP.NET 3.5 SP1  refers to the version number of asp.net that is installed on a server. There is no such thing as a sp1 being applied to asp.net 2.0 - thats just nonsense talk. The server will either have asp.net 2.0  OR  asp.net 3.5   OR  asp.net 3.5 SP1 ( which means the service pack patch for 3.5)

Instead its more likely he is talking about the SERVER operating system and which operating system service packs etc are installed on said server.

Either way - bite the bullet and MOVE