You shouldn't change anything about the service, you should change the connection string to include a user defined on the SQL server. Undo your changes, add a user to SQL server, update your connection string, then it should be working.
After many hours work and a lot of reading, I managed to get it working with sql authentication. I had to alter settings in visual studio, sql server management studio, the sql server service and my web.config and code behind files.
Just in case anyone is reading this and is in the same position as me, I've written up my own instructions for making SQL Server work with ASP.net. These instructions will help you get a database connection working with "SQL Server Authentication":
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Configuring VS and SQL Server to work together
SQL Server Management Studio Part
To set the general settings for management studio right click the computer name at the top of the tree and go to "properties".
Security
Set the "server authentication" method to "sql server and windows authentiation mode".
Set "failed logins only".
Open security > logins > right click logins and select "new login".
General
Select SQL Server Authentication
Uncheck "Enforce password policy".
Set the default database.
User Mapping
Select the required databases from the list marked "users mapped.."
Check the box which says "db_owner" from "database role membership for: master".
Securables
(taken from
http://imar.spaanjaars.com/QuickDocId.aspx?quickdoc=395)..
There's a fair chance that only reading and writing to tables is not enough. For instance, you could have a number of stored procedures that the user account must be able to execute as well. To grant the account execute permissions on your procedures, click Securables in the left hand pane and click the Add button. In the dialog that follows, choose All objects of the types and then click OK. Then check Stored Procedures and click OK. The list with Securables will be filled with a number of stored procedures, including your own. Locate your stored procedure, and then make sure at least Execute is selected in the Grant column of the Explicit permissions box.
Visual Studio Part
Under "data connections" in the "server explorer", right click the database and click "modify connection".
Set the authentication method to "use sql server authentication" and enter the username and password for the account configured in "sql server management studio".
Select the required database in this screen also.
Click test database to check it works.
Click "advanced" and copy the database string used in the connection code.
Services Part
Visit
windows+r > type services.msc and go to properties for "SQL Server".
Go to "log on".
Enter "Network Service" and no password. To do this:
Go to "Browse" > "Advanced" > "Find Now" > Select "Network Service" > Ok > Enter no password > Ok > Restart the "SQL Server" service.
IMPORTANT: The "network service" account is equivalent to the ASPNET account often mentioned for windows XP. Aparently network service is used on "windows server 2003", but also on Vista/win7 it seems.