I have the same problem. I tried setting both basic and digest(what i would like) and set the domain to our domain but the login box always looks to login to the server first. This setup worked in ii6 wondering what the trick to get it to work in ii7 is.
As it seems it does work when i dont have windows authentication checked but then it trys to make an anonymous connection to my sql server. With windows authentication on, I can make my connection but then i have to do domain\user to login remotly