I am also experiencing the same issue.
A week ago, I installed 2.0 Framework on dev webserver that already had 1.1 on it.
Deployed my new 2.0 application, set IIS to ASP.NET 2.0 and everything worked fine.
Just today, started getting errors. First was this error: Unrecognized Attribute 'xmlns'
I noticed from the error page that it was using the 1.1 Framework even though IIS says 2.0.
I ran aspnet_regiis -i and that moved me past this error on to:
allowDefinition='MachineToApplication' beyond application level
Ironically, I also have already followed the steps mentioned above, in removing the Application, recreating the Application using it's own application pool.
I will post back once I determine the final solution.