So you have used update panels before.  And the same code you may have used in an AJAX enabled website does not work when you put it into a Web Application.

I struggled with this for several hours before discovering that if you have the following line in your web.config file it breaks ASP.Net AJAX.

I have not researched the reason behind this but I plan to do so and will give an update when I find more information.  Just know that you can comment out this line or change the mode from Legacy and your Update Panel should start working.  Let me hear from you if you know why this breaks ASP.Net AJAX or if removing this config entry does not clear your problem.

UPDATE: 2/5/2008

Found that this config file entry is created when migrating from VS 2003 to VS 2005 and can occur with Web Applications and Websites.  For a deeper understanding Scott Guthrie sheds some insight.