It seems to me you have to make two decisions: what data model to use, and what storage engine to use. It sounds as if it's appropriate to use XML as your data model and a database engine for data storage, so you should do that: they aren't in conflict. Whether SQL Server 2005 is the best database engine for storing XML is another question.
Michael Kay
http://www.saxonica.com/
Author, XSLT Programmer's Reference and XPath 2.0 Programmer's Reference