Ensure the firewall is enabled on both the client and the server, and the correct inbound exception is created on the server. There is never a valid reason to disable the firewall in Windows. Since its overhaul with Vista, the firewall has taken on additional roles in securing and authenticating network traffic, and I've noticed frequent issues with clients disabling the firewall to "speed things up" or "work around potential problems", and it's caused nothing but grief.
Regarding SP1 causing timeouts, depending on your client configuration you may need to reinstall SQL Server native client drivers, reconfigure system or user DSNs if you use them, or other things. I have not noticed any issue when using the SQL Server native client drivers when using connection strings in UDL files for client line of business applications, and we have a mix of clients running XP SP3, Vista SP2, Windows 7 and Windows 7 SP1 at the moment.
Unfortunately I cannot comment on your post to solicit additional information, so I'll just ask if you have any group policies that mandate or control authentication or encryption between clients and servers that would affect Kerberos/AD/Windows Authentication? I'm not aware of any changes in SP1, but that could also potentially cause an issue.