You may have run into this error while trying to develop a site that uses Integrated Windows Authentication on Windows Server 2008 R2 with IIS7.5. I sure did, and I beat my head against the wall for a couple of hours trying to figure it out.
It turns out to be a security mechanism built into Windows, and the workaround is simple. Just choose one of the two methods listed in this Microsoft KB article:
You can find a more detailed explanation here:
Hope this saves you some time.
(h/t to this ServerFault.com question/answer: IE 8 Authentication Denied on local SharePoint Site)