Vinayak,
I'm working throught setting up SER and came across the problem with MySQL 4.1.7 too
and sorted it out through changing old passwords this way:
I did it for users ser and serro.
mysql> UPDATE mysql.user SET Password = OLD_PASSWORD('newpwd')
-> WHERE Host = 'some_host' AND User = 'some_user';
mysql> FLUSH PRIVILEGES;
hope this will help
Lada
PS: it works even without starting mysqld and parameter --old_passwords