Hmm Im thinking of just reformatting the server and downgrading it with installing 2003 R2 and then reinstall sql 2005 sp-2. I will make sure the collations match this time. For some reason I rebooted the server and the collation issue seems to have gone away.

If your connectionstring passes an appropriate user account it shouldnt matter if its in a workgroup or domain but the ability for one system to access the other is crucial. I thinkaccess is not an issue as I can see the server in net neighborhood and even logon.

Just a bit stumped here on this one.