database.yml

# Connection to SQLServer with activerecord-sqlserver-adapter (2000-2005) locally on Windows
development:
  adapter: sqlserver
  dsn: Database_DSN
  mode: odbc
  username: user
  password: password
  encoding: utf8

Connection to SQLServer with activerecord-sqlserver-adapter (2000-2008) locally on Windows

development:
adapter: sqlserver
host: localhost/or your IP address
database: mydbrails
port: 2301 -- make sure on SQL server configuration manager you have configured under Protocols TCIP/IP IPALL for example MSSQLSERVER example for me TCP port: 1433,2301
username: mydbrailsuser
password: password

This is now on your database.yml.
development:
adapter: sqlserver
host: localhost
database: rubysqldb
port: 2301
username: rubysqldb
password: password

Make sure to create you database example "rubysqldb" first via SQL Server management Studio with the following access:example my user: rubysqldb has access: Database Role membership: db_owner