WOW - I Just got this exact issue to work and it was such a simple fix, but took soo many hours to find.

If you want to do a automatic login for active directory, yes, you follow the manual and yes to set it up for Windows Auth. BUT - I made the mistake of making the site a trusted site. - You don't want it to be a trusted site. You need to make it an intranet site. If you have IE7 - go to tools -> Internet options -> security tab -> local intranets icon -> sites button ->advanced -> add site as intranet site.

Doing that prevented me getting the login pop up box. -So it appears that for the automatic Login (takes your windows machine's credentials and passes them to Active directoryfor authentication) to work, you have to have this setting in place or else you will get a pop up window every time your users try to login.

Also, I'm running IIS 7 and SQL 2008 express on a win2008 box. You have to run the application pool in classic mode and I am running the site with inpersonate on, no anonymous access - BUT I do have forms and Windows Auth. Activated. When I disabled forms, the site went into an infinate loop. Even though the mesage at the top says you need to disable one of them - don't. It works. Also, I didn't have to modify the web.confi file.

I'm done with this issue and won't be monitering this thread. - if anyone has a question, email our general email address. You can find it at www.DallasPartners.com

Good Luck.