I have just spent the evening trying to troubleshoot this problem. This seems to be server related.
IIS 6 > Windows 2003
On this server, KFM will not upload any files. I am getting the error mentioned in the previous post. I can create/delete folders, but I cannot upload any files.
IIS7 > Windows 2008
I copied the site over to this server to give it a try. Uploading works fine with the exact same configuration.
HOWEVER - I have a new problem on IIS7. When I go to insert an image or file, it is setting the entire disk path (d:\sites\etc... etc...) rather than the relative path "/resources/images/etc... etc...". For the record, on IIS 6 the insert paths are correct. This is only happenning on IIS7.
So here is what I have with an identical site in two locations.
IIS 6 won't upload any files.
IIS 7 won't display without manually altering the path to the files.