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Some Windows XP users (not all) are reporting problems trying to set up Web Folders. Unfortunately, Windows XP has at least one bug which can prevent Web Folders from working. It has to do with the way the username and password are sent to the server; in some cases, XP does not do this correctly. This problem was confirmed by Microsoft in July of 2003. (There is some speculation that the bug may be related to the combination of Windows XP and Microsoft Office or Microsoft Office XP, but this has not been fully clarified.)
It is up to Microsoft to fix this; perhaps they will in a forthcoming patch. Unfortunately, there is very little that we can do about it on our end. There is a Microsoft Knowledge Base Article about the problem here:
Cannot Add FQDN Web Folders that Require Basic Authentication to "My Network Places"
The solution to the problem from Microsoft's perspective appears to involve an assumption that the server hosting the Web Folder is running Microsoft software. LiteracyTent runs Linux, so this solution may or may not work for you.
You might try contacting Microsoft Support for assistance if you are affected by this problem. We will keep this page updated as we learn more, and hopefully a fix will emerge at some point.