Well, I have spent 2 days now and probably 3 hours myself and 2 hours with another friend with my PSP and internet.
I had 4.01 firmware, and first to let everything be known, I'm pretty knowledgeable about internet, computers, the psp and wireless securities and settings, including port forwarding, WPA2, WEP encryptions.
Ok, i had 4.01 firmware, I tried to connect to my secured internet, the psp detected it, i entered my key and yes the PSP wireless switch was turned on, otherwise it tells you to turn it on.
Internet didn't work...connection timed out.
So i change the security setting on my router and try again. And I did and still have internet correctly working.
...connection timed out.
change another setting.... connection timed out.
turn security completely OFF and try and connect..... CONNECTS AND DOES EVERYTHING FINE.
turn security to WEP and create key, save key, put key in PSP ...etc
....connection timed out.
tried my friends network that his psp & wireless laptop works on....connection timed out.
So WTF, my PSP will connect to unsecured networks but no secured ones?? does anyone have the slightest clue?
Well I know for a fact that the PSPcan connect to secured wirelesses (My own is WEP protected as well). However, after that I can't help you since my own problem doesn't let me test such things. :(
There is one thing, did you do auto-mode for all other settings other than the encryption method (which I assume you set to the same one that you set in your router, or whatever, menu)?