After installing all outstanding updates on the WSS Developer VM I started getting unexpected prompts for authentication.
First I tried disabling the loopback check as per KB896861. Unfortunately, no luck.
Seems the issue had to do with IE detecting the wrong zone. It was detecting the Internet zone whilst I'm clearly in the Intranet zone (ie URL was http://spvm).
Solution was to uncheck "Automatically detect intranet network" at:
Internet Options->Security tab->Local intranet->Sites button
Windows SharePoint Services 3.0 SP1 Developer Evaluation VPC Image
You receive error 401.1 when you browse a Web site that uses Integrated Authentication and is hosted on IIS 5.1 or IIS 6