Prompt for authentication when opening office document from webserver

Hi there,
After deploying win7 at my edu institution, several faculty have complained that they are unable to open office documents (docx, pptx) directly from our online teaching website (webCT).   When the users click on an office document --> open, (as opposed to save) a dialog box appears pointing to the URL path of the file and a "windows Security" window appears prompting for a username and password to connect to the site (https).

These dialogs appear underneath IE8.  It is not very apparent to the frustrated end-users why the document won't open.  

Furthermore, after entering any username/pw 3 times the authentication quits and the corresponding office app launches and loads the document (read-only).  Cancelling the authentication prompt has the same result; it loads normally (read-only).  This leads me to believe that there is no authentication taking place.  The app is simply recognizing the path as an https and wants to be ready with a username/pw should you wish to edit.

I added the site to "trusted sites" and toggled "Enabled Integrated Windows Authentication"
Also, in internet Options --> Security --> Trusted Sites --> Custom Level, I tried all 4 bullets under "User Authentication--> Logon" to no avail.

The issue is not reproducible on winXP with IE8 nor in firefox: winXP or win7.
It feels as if the browser recognizes the file type and loads the associated Office application which tries to load the file straight from the webserver (https).  Whereas before it loaded a cached copy, now its trying to 'check-out' the document almost as if it was on a sharepoint.

I'm looking for a way to bypass this "username/password" dialog so that the documents load normally (the way they used to before upgrading to win7)  with an IE8 setting, registry edit, or something that I can add to group policy.
Thank you for your help,
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When the users are being prompt to enter the UN and Password, they enter in their Blackboard Credentials? also have they tried to select save, and saving a local copy. Maybe this has nothing to do with the security on your end as well, maybe contact blackboard direct others may be having the same problem with their services.
khiggins1979Author Commented:
The blackboard credentials fail (return to UN/PW) as well as the users domain credentials.  after any 3 attempts, it just loads the file.
I contacted our Blackboard helpdesk this morning (outsourced) who told me to have all the users load it in firefox and that IE8 isnt supported.
I really don't want to have to tell my CIO that firefox is our resolution.  We've had the college on IE8 for a long while now and nobody has complained about this issue until we started to refresh with win7 this winter (we skipped vista.)  Since I can't reproduce it on an XP box, I'm really looking for something I can do to my win7 image for a long term fix.
After bumming around Blackboards sites I found this and I'm guessing they are not going to provide you anything else than "Try using Firefox". I am not currently on my Win7 machine, I would like to see if I get similar errors on a home client. (I take some online courses through blackboard) Hopefully someone here could suggest something in the meantime.

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khiggins1979Author Commented:
I'm going to leave this open for a few more days to see if anybody else chimes in.  Its a very low priority issue and has an obvious work-around, but the helpdesk would like to see my team hedge some of their calls and none of us can find decent resolution.

From what I've read from technet, this is as-designed and specific to win7/internet explorer. Perhaps blackboard will make things work more user-friendly from their end in the future.

Thanks for following up Speet42.
khiggins1979Author Commented:
This issue is unresolved.
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