The issue has been solved, thanks to forum member Snakeblood...for general public knowledge purposes, I am posting the solution here:
This seems to be a known issue when using a local MSDE and is caused by the absence of two protocols. To enable these two protocols, go to the MS SQL Server folder in "Program Files\Microsoft SQL Server\80\Tools\Binn\" and run the application: "SVRNETCN.exe". Here enable 'Named Pipes' and 'TCP/IP' protocols.
Then restart MSSQLSERVER service and restart the BES
You need to put in the correct port number that your SQL server is using for the BES database. So when you install and it asks for the database name, you would type in (databasename\instance, portnumber)
I had the same problem and everything is good to go now. BTW, if you go to SP2 you won't have this problem.