Scenario: A WCF service hosted in IIS that is invoked from another WCF service or ASP.NET application hosted in IIS on the same machine, throws the following error:
                 "The HTTP request is unauthorized with client authentication scheme 'Ntlm'. The authentication header received from the server was 'Negotiate,NTLM"'.
The key here is that it fails only for local requests. If you call the same WCF service from a different server, it works fine.

One possible cause of this issue could be the DisableLoopbackCheck introduced in Windows Server 2003 SP1. The following article talks about this.
926642 Error message when you try to access a server locally by using its FQDN or its CNAME alias after you install Windows Server 2003 Service Pack 1: "Access denied" or "No network provider accepted the given network path"
http://support.microsoft.com/default.aspx?scid=kb;EN-US;926642

A quick test to find out if you are running into this issue is turn off disable loop back check(Method 2 in the article above). If this fixes the issue, you should use the Method1 from the article above for a long term solution.

Method 1 (recommended): Create the Local Security Authority host names that can be referenced in an NTLM authentication request

To do this, follow these steps for all the nodes on the client computer:

  1. Click Start, click Run, type regedit, and then click OK.
  2. Locate and then click the following registry subkey: HKEY_LOCAL_MACHINE\SYSTEM\CurrentControlSet\Control\Lsa\MSV1_0
  3. Right-click MSV1_0, point to New, and then click Multi-String Value.
  4. In the Name column, type BackConnectionHostNames, and then press ENTER.
  5. Right-click BackConnectionHostNames, and then click Modify.
  6. In the Value data box, type the CNAME or the DNS alias, that is used for the local shares on the computer, and then click OK.

    Note Type each host name on a separate line.

    Note If the BackConnectionHostNames registry entry exists as a REG_DWORD type, you have to delete the BackConnectionHostNames registry entry.
  7. Exit Registry Editor, and then restart the computer.

Method 2: Disable the authentication loopback check

Re-enable the behavior that exists in Windows Server 2003 by setting the DisableLoopbackCheck registry entry in the HKEY_LOCAL_MACHINE\SYSTEM\CurrentControlSet\Control\Lsa registry subkey to 1. To set the DisableLoopbackCheck registry entry to 1, follow these steps on the client computer:

  1. Click Start, click Run, type regedit, and then click OK.
  2. Locate and then click the following registry subkey: HKEY_LOCAL_MACHINE\SYSTEM\CurrentControlSet\Control\Lsa
  3. Right-click Lsa, point to New, and then click DWORD Value.
  4. Type DisableLoopbackCheck, and then press ENTER.
  5. Right-click DisableLoopbackCheck, and then click Modify.
  6. In the Value data box, type 1, and then click OK.
  7. Exit Registry Editor.
  8. Restart the computer.

Note You must restart the server for this change to take effect. By default, loopback check functionality is turned on in Windows Server 2003 SP1, and the DisableLoopbackCheck registry entry is set to 0 (zero). The security is reduced when you disable the authentication loopback check, and you open the Windows Server 2003 server for man-in-the-middle (MITM) attacks on NTLM.


The same scenario could also occur in case of an asp.net application calling a webservice(.asmx) locally.
The following blog discusses the details about this issue.
http://blogs.msdn.com/lukaszp/archive/2008/07/18/reporting-services-http-401-unauthorized-host-headers-require-your-attention.aspx