I’ve got an Xserve running, among other things, iChat server. To tidy things up, I wanted to have all users with a login of something like user@example.com rather than user@server.example.internal, but after adding the extra domain into iChat server, iChat couldn’t log in as user@example.com

It turns out that it may be something to do with MD5 authentication.

The solution I used to fix it was:
Stop the iChat Server: sudo launchctl unload /System/Library/LaunchDaemons/org.jabber.jabberd.plist

Edit the file /etc/jabberd/c2s.xml with a text editor and remove <digest -md5/> option by commenting it out thus <!– <digest-md5/> –>

Restart the iChat server: sudo launchctl load /System/Library/LaunchDaemons/org.jabber.jabberd.plist

(Solution from Apple Discussions)