Might be a Codec problem. There is a new Windows Media Player ver 10 which is a beta. It is meant for XP but it may also work with 2K3. This is the page: http://www.microsoft.com/windows/windowsmedia/mp10/default.aspx

Yes, thank you...I was aware of the beta but was wary to give it a try, esp. a Microsoft beta....I'll give it a shot...it must be a native codec installed with WMP that all video playback programs use that is incompatible...When I try dvd playback in windvd 6 with DD/D3D acceleration disabled it says "Create overlay failed". Otherwise it locks up with the accelerations. Well, I'll report back on WMP10!

Nope, no luck...it says "Can only be installed on widows xp (32-bit)..." on setup screen. Any other ideas?

Ok. It is possible that your Direct Draw Function may not be working. Try this:
Click on Start / Run/ dxdiag /click OK
Click on Display Tab at the top..(after inital test which takes a few seconds)
Click on the Enable Button next to DireceDraw Acceleration

Went to intervideo's error page (which should work also for WinDVD) and these are the things suggested with the overlay message:
 
Step 1 (Microsoft Windows NetMeeting):
If you are using Windows XP or 2000 then check to see if you have NetMeeting running. Click start, programs, accessories, communciations, and open the NetMeeting software. Now go to tools, options, and go into the video tab, uncheck the video options in the sending and receiving video box. Apply the settings by clicking OK. Now, restore the previous settings, you currently unchecked, and re-apply everything by clicking OK. Exit NetMeeting, and make sure its icon is still not showing in the system tray (found in the lower-right corner of the screen). Now try running a DVD title with WinDVD.
Step 2 (video card driver):
Upgrading the graphics card driver to the latest version shown on the video card vendor website. Do not assume you have the latest video card driver in your system without checking.
Step 3 (verification of DirectX version currently installed):
Go to start, run, and type in dxdiag and press enter. A diagnostic tool will open then click on display and under display you will see DirectX Features. There are 3 acceleration settings (DirectDraw, Direct 3D, and AGP Texture). If they are indicated as Not Available and Disabled then this is another reason why you are getting the error message when playing WinDVD. Try downloading DirectX 9 if you have an older version on your system.
Step 4 (other applications that can corrupt the video overlay):
If you are running PC Anywhere, or the Microsoft Windows XP Remote Desktop, make sure you turn that off before running WinDVD.
Step 5 (hardware acceleration):
Go to Start then open the control panel, open Display. Under the settings tab click on advanced, under the Troubleshoot tab make sure that the Hardware Acceleration slider is set to full. If not you will need move it to full then click Apply.
 

DirectDraw and Direct3D accelerations are what CAUSES the problems (as stated previously), which is why I disabled them, because if I leave them enabled video playback locks up no matter what the video format no matter what the player. I already tried the windvd problem but no cigar, besides it is not an inherent problem with windvd as all video formats are affected and dvd playback does not work in WMP9 either. No official drivers provided by Compaq (my manufacturer) nor modded ATI drivers allow vid playback with DD/D3D acceleration. This extends to dvd playback. When I disable these accelerations, the video files work (as stated previously) but DVD playback still does not work and generates a "Cannot create overlay". And, as stated previously, there are NO updates available, meaning I have DirectX 9b. Please help.

To rule out other possibilities, I've also tried reinstalling DX9b and WMP9 codecs, as well as installing WMP8 codecs, but still no luck. DirectX diagnostics report all DirectDraw and Direct3D tests are successful when I test them, but unless I disable them lockups occur during video playback.

Also, everything worked perfectly in WinXP Pro with the same drivers tested.

Then it has got to be a driver issue. you just have to wait untill they come up with drivers for the OS.

Have two alternative suggestions but they are a little in left field:
1)Go into regedit and check to see if the timeout value is set to 7 Hexadecimal. This is the standard timeout for XP
HKEY_LOCAL_MACHINE\SYSTEM\CurrentControlSet\Control\GraphicsDrivers\DCI\Timeout value to 7 (hex).
2)2k3 may include a driver called darpan.sys which is really a Novel driver. If it does have it, this has been known to create and overlay that conflicts with WinDVD.

One more suggestion found from someone who is running 2k3 with and ATI card. This was his full message when he had the overlay problem:
 
"For all the people who are having the same problem, i hope that this
can help you out.
 
I had installed w2000 server with DVD software and it worked fine, so
i installed dual boot W2003 server and now suddenly i get the subject
error in InterVideo WinDVD 4. So for all those people, it isn't a
hardware issue.
 
So i update directx, windows updates, screen resolutions, full
accelaration and that didn't work. But the solution is in your video
adapter software, i reinstalled the ATI rage family
w2k-j5-30-1-b02.exe adapter and problem solved."
 

Well, I checked with ATI's support site...apparently Server 2k3 currently supports drivers for Rage XL products only. They then state that,
 
"Windows Server 2003 is positioned as a business and corporate enterprise server Operating System. It is not intended for home or personal use."
 
What a gyp.
 
Thx for trying to help but you can't fix ATI's neglect.