I might be no help here at all but have you made sure that it's SQL authentication (I can't remember but I thought that this would be the case) and also make sure that you're using the right network protocol in MSDE. I seem to have a vague recollection that you can only use certain protocols on 98. I would try TCP/IP and then named pipes but I kind of think named pipes may not work. I could be wrong though, sorry.
Thanks for your suggestion. I did set the securitymode = SQL on the msde. I have tried both TCP/IP and named pipe and none seems to work. I am going to do some more research about the TCP/IP and named pipe to make sure that I have them setup right.