Ok... can you post the content of your .htaccess file again? Just want to make sure we're on the same page.
Also, are you viewing file extensions in Windows? To check, open My Computer, click Tools, click Folder Options, click the View tab, and make sure the box that says "Hide extensions for known file types" is unchecked. Then verify that the two files are indeed ".htaccess" and ".htpasswd" respectively, nothing more (such as an extra .txt on the end).
EDIT: Also, open up your httpd.conf file for Apache, and look for the <Directory> listing that contains the htdocs folder (for example, mine said <Directory "C:/Program Files/Apache Group/Apache/htdocs">). Inside that <Directory> tag, look for an "AllowOverride" directive. What is it set to? "All"? "None" ?
Also, search the .conf file for the keyword "AccessFileName". Do you find "AccessFileName .htaccess" ?