You did not provide the samba version. I'd update to 3.0 if possible. However, you are correct the issues you are dealing with are encryption and the smbpasswd file. Turn encryption on and ensure that smbpasswd is updated. I normally just use webmin to setup samba - ensures that the conf file is correct and working. Might chech out swat also.

PS if you have no need of security just use the nobody (guest) account.
John