I'm just trying to create a new application pool in IIS7 and specify 3.5 for its framework version. However it only has "v2.0.50727" or "no managed code" as options in the framework version drop down.
How can that be and how can I fix it?
This is correct.
As long as you have .net 3.5 installed on the box then .net 3.5 web apps will run.
"ASP.NET 3.5, it is still based on the ASP.NET 2.0 core fundamental. Therefore, there is no new application type(for ASP.NET 3.5) in IIS"
Taken from here: link text
There is no separate version for .NET 3.5, because the core runtime with .NET 3.5 is still v2.0.50727. .NET 3.5 is just extra classes and new compilers layered on top of the 2.0 runtime. Just pick 2.0
The above two answers are true. Additionally, note this means there is no reason not to "upgrade" to .NET 3.5 (SP1). As far as existing .NET 2.0 code is concerned, this release is just a service pack (.NET 2.0 SP2 to be precise).