So do you have other .NET 3.5 apps working on the box?
Do you see an ASP.NET tab in IIS settings? If so make sure you choose 2.0 (there won't be an option for 3.5 because it's really a superset of 2.0). If not it means something did not go right with aspnet_regiis, make sure you run it from the Framework 2.0 folder nested down under the windows directory, otherwise you may be just reconfiguring 1.1 .NET.
Also make sure you are not using the same application pool for any 1.1 .NET apps, a 2.0 app cannot use the same app pool with 1.1 apps.
You might also try chopping out some of the IIS 7 specific stuff from Web.config though it should be able to ignore it. I would try remove the entire system.webServer section as well as the system.ServiceModel section and possibly also the system.web.extensions section, the system.codedom and runtime sections and see if any of that makes a difference.
Hope it helps,
Joe