>>>
>>>go to Tools -> Options -> Database Tools -> Data Connections. There is an option there to set the server instance name to use.
>>
>>Presumably that only sets the default? Did you try backing up a couple of frames in the Wizard to select from there ?
>>Doesn't matter since you got it working - just curious.....
>>
>
>I'm not sure what Wizard you are referring to. I don't get an option to select the data connection anywhere. My steps were:
>
>1. In VS2008, right click on project, choose Add | New Item...
>
>2. Choose "Service-based Database" and give it a name, then click on Add.
>
>3. At this point I got the error, now when I've switched it to SQLEXPRESS2008 it works.

I was referring to the original scenario where you achieved a connection to the SQL2005 server. That would have got you as far as the Configuration Wizard - at which point my suggestion of backing up and switching to the SQL2008 server should have worked.....
Regards,
Viv