Under the <configsections> tag add:
<sectionGroup name="system.web.extensions" type="System.Web.Configuration.SystemWebExtensionsSectionGroup, System.Web.Extensions, Version=3.5.0.0, Culture=neutral, PublicKeyToken=31bf3856ad364e35">

Under the <safecontrols> tag add:

Under the <compilation> tag then <assemblies> tag add:
<add assembly="System.Web.Extensions, Version=3.5.0.0,
Culture=neutral, PublicKeyToken=31bf3856ad364e35"/>
<add assembly="System.Web.Extensions.Design,
Version=3.5.0.0, Culture=neutral,
PublicKeyToken=31BF3856AD364E35" />
<add assembly="System.ServiceModel, Version=3.0.0.0,
Culture=neutral, PublicKeyToken=b77a5c561934e089" />
<add assembly="System.ServiceModel.Web, Version=3.5.0.0,
Culture=neutral, PublicKeyToken=31bf3856ad364e35" />

Under the <system.web> tag then <httphandlers> add:
<add verb="*" path="*.asmx" validate="false"
type="System.Web.Script.Services.ScriptHandlerFactory,
System.Web.Extensions, Version=3.5.0.0, Culture=neutral,
PublicKeyToken=31bf3856ad364e35"/>
<add verb="*" path="*_AppService.axd" validate="false"
type="System.Web.Script.Services.ScriptHandlerFactory,
System.Web.Extensions, Version=3.5.0.0, Culture=neutral,
PublicKeyToken=31bf3856ad364e35"/>
<add verb="GET,HEAD" path="ScriptResource.axd"
type="System.Web.Handlers.ScriptResourceHandler,
System.Web.Extensions, Version=3.5.0.0, Culture=neutral,
PublicKeyToken=31bf3856ad364e35"
validate="false"/>

Under the <system.web> then <httpmodules> tags add:
<add name="ScriptModule" type="System.Web.Handlers.ScriptModule,
System.Web.Extensions, Version=3.5.0.0, Culture=neutral,
PublicKeyToken=31bf3856ad364e35"/>

Under the <pages> tag add:
<controls>
<add tagPrefix="ajaxToolkit" namespace="AjaxControlToolkit" assembly="AjaxControlToolkit" />
<add tagPrefix="asp" namespace="System.Web.UI" assembly="System.Web.Extensions, Version=3.5.0.0, Culture=neutral, PublicKeyToken=31bf3856ad364e35" />
<add tagPrefix="asp" namespace="System.Web.UI.WebControls" assembly="System.Web.Extensions, Version=3.5.0.0, Culture=neutral, PublicKeyToken=31BF3856AD364E35"/>
</controls>

Under the <assemblyBinding> tag add:

At the end of the file before the configuration end tag add:
<system.webServer>
<validation validateIntegratedModeConfiguration="false" />
<modules>
<add name="ScriptModule" preCondition="integratedMode" type="System.Web.Handlers.ScriptModule, System.Web.Extensions, Version=3.5.0.0, Culture=neutral, PublicKeyToken=31bf3856ad364e35" />
</modules>
<handlers>
<remove name="WebServiceHandlerFactory-Integrated" />
<add name="ScriptHandlerFactory" verb="*" path="*.asmx" preCondition="integratedMode" type="System.Web.Script.Services.ScriptHandlerFactory, System.Web.Extensions, Version=3.5.0.0, Culture=neutral, PublicKeyToken=31bf3856ad364e35" />
<add name="ScriptHandlerFactoryAppServices" verb="*" path="*_AppService.axd" preCondition="integratedMode" type="System.Web.Script.Services.ScriptHandlerFactory, System.Web.Extensions, Version=3.5.0.0, Culture=neutral, PublicKeyToken=31bf3856ad364e35" />
<add name="ScriptResource" preCondition="integratedMode" verb="GET,HEAD" path="ScriptResource.axd" type="System.Web.Handlers.ScriptResourceHandler, System.Web.Extensions, Version=3.5.0.0, Culture=neutral, PublicKeyToken=31bf3856ad364e35" /></handlers>
</system.webServer>

You are now ready to use AJAX controls including the update panel on the SharePoint.

Devvawy

How to configure AJAX 3.5 on Sharepoint (MOSS)