On W2003 Server and Vista the IIS application pool account of the web site must somehow be granted "Modify" rights on the VPP file tree because it is this login account identity that wants to write files into this file area when an editor uploads images and documents via the File Management tool. Commonly this app pool account is NETWORK SERVICE. It could also be a domain account which must be a member of the local machine's IIS_WPG group account. Depending on your security preferences grant recursive Modify rights over the whole of the VPP tree to the app pool account in use or a group of which it is a member on the local machine (usually IIS_WPG).
On Windows XP however, it is the machine\ASPNET account that is running the web site, so it is that account that needs Modify permssion in this case. There is no need to grant modify rights to the ASPNET account on W2003 or Vista.
This isn't any different to what you had to do in EPiServer 4.6n with the /docrepository, /upload etc. folders, it's just that CMS5 now checks on startup that you've done it else the File Management facility is not much use in edit mode.
Also make sure that the paths defined on the "physicalPath" attributes in the <virtualPath> config section in web.config are referencing the correct physical folders. If you deploy your site from a development machine to a server without using EPiServer manager to install the site, you may forget to redefine the folder paths to the ones in use on the server. EPiServer will try to create the folders using the existing path definitions as defined on your dev machine, then will complain about the modify rights not being present, which of course they aren't because you didn't set them there. You can waste a lot of time with that one.
Thanks Everyone, Solved my issue
On Server 2008 R2 and CMS 6 R2 this will help:
See http://learn.iis.net/page.aspx/624/application-pool-identities/ for details.