<p>I have IIS 5.1 installed on Windows XP Pro SP2. Besides I have installed VS 2008 Express with .NET 3.5. So obviously IIS is configured for ASP.NET automatically for .NET 3.5</p>

<p>The problem is whenever I access <a href="http://localhost" rel="noreferrer">http://localhost</a> IE &amp; Firefox both presents authentication box. Even if I enter Administrator user and its password, the authentication fails. I have already checked the anonymous user access (with IUSR_ user and password is controlled by IIS) in Directory Security options of default website.</p>

<p>However other deployed web apps work fine (does not ask for any authentication).</p>

<p>In IE this authentication process stops if I add <a href="http://localhost" rel="noreferrer">http://localhost</a> in Intranet sites option.</p>

<p>Please note that the file system is FAT32 when IIS is installed.</p>

<p>Regards,
Jatan</p>

It could be because of couple of Browser settings. Try with these options checked..
Tools > Internet Options > Advanced > Enable Integrated Windows Authentication (works with Integrated Windows Authentication set on IIS)
Tools > Internet Options> Security > Local Intranet > Custom Level > Automatic Logon
Worst case, try adding localhost to the Trusted sites.
If you are in a network, you can also try debugging by getting a network trace. Could be because of some proxy trying to authenticate.