I am running into the exact same problem.  I followed all the instructions and accepted all the defaults for local file system installation where the database is the default .mdf file for use w/ SQL Server 2005 Express.  I am running XP Pro and using Visual Web Developer 2005 Express and IE7.  I do have the full standard SQL Server 2005 installed as well but I am not using it for this now.  I even went and manually added the ASPNET (ASP.NET Machine Account) user to the list of users for the root project folder of the Website that is created by the install and compile.   It was not listed when I checked it after the installation was completed and thought that might be the issue...but no luck.  When I try to hit the URL: http://localhost:4702/DotNetNuke%20Website1/Default.aspx  (which is the local dev server (port number may vary) that is used w/ VWD ... all I can ever get is the page w/ the text:

Internet Explorer cannot display the webpage
  
   Most likely causes:
You are not connected to the Internet.
The website is encountering problems.
There might be a typing error in the address.
 
   What you can try:
     Diagnose Connection Problems 
 
     More information

Try this:

Setting-up Your Development Environment

• Setting-up the Environment (using IIS)
• Setting-up the Environment (without IIS)