Here’s the fix I found and it worked for me:
The issue is due to the application pool configuration. For this please
create a new application pool in Windows 2003 server named XYZ ( or whatever
name you want ). Then assign a user name/pwd for this application pool
context and make that user to be under the group of both Biztalk application
users/isolated users. Then the web service you are exposting should execute
under this application pool context. for this go to IIS and right click the
web service directory and click properties. Under the directory tab select
the application pool you created. Then restart the box and test it again.