CJM,
Are you using apache using wsgi? if so, you're with me. You cannot
import pyodbc.
http://ochiba77.blogspot.com/2011/10/how-to-setup-web2py-apache-wsgi.html
If you're using rocket server, it should connect because I'm
connecting without any problem. Only difference with your environment
is that I'm using Windows 7. I use actual server(computer) name
instead of localhost. You can try that to see if it makes any
difference.
db = DAL('mssql:// testUser:password1@ServerName/testDB')
if it's mssql server express,
db = DAL('mssql:// testUser:password1@ServerName\SQLEXPRESS/testDB')