That is very strange but seems like a problem with the connection to the sql server rather than problem caused by the reporting product. Can you try using the same connection and stored procedure to bind a standard .NET2.0 GridView control and verify that the login credentials work?
You can also try using Windows Authentication by setting Trusted Connection = TRUE or Integrated Security = SSPI in the connection string
and see if it works that way.
All the best,
the Telerik team