I also had this issue and found it was linked to SQL connectivity and firewall settings.
You must have:
SQL Server browser enabled.
IP protocol enabled.
SQL set to use fixed IP ports, SQL 2005 Express defaults to using dynamic ports.
Firewalls configured to pass both the SQL server instance port and the SQL server browser port (1433 & 1434 are the defaults).
For more information the following link is excellent:http://msdn.microsoft.com/en-us/library/ms175043.aspx