Having samba 3.0.6. man smb.conf, the section abdout encrypt passwords: The problem is that smb.conf is being read BOTH by smbd and smbclient. So it is not clear what the description of encrypt passwords is valid for: whether smbd, smbclient or both. It could control the behaviour of smbclient when starting the session or smbd. Suggested fix: write there, which case this is a description of (or whether of both).
*** Bug 1699 has been marked as a duplicate of this bug. ***
This entry clearly says : This boolean controls whether encrypted passwords will be negotiated /with the client/.