If you haven't, try connecting with Enterprise Manager or some other sql server tool to verify that your connection parameters are valid, use the same server name, username and password.
I use similar syntax on my xp pro development machine with sql server 2000, IIS 5.1 and php 5.0.4 without problems, connecting to the server on the same computer.
You could try disabling any firewall software or antivirus script blocking software for testing (assuming this doesn't expose your computer to the outside world).