When adding a new data connection in Server Explorer in VS 2010 (with Azure SDK), I can successfully \"Test Connection\" but when adding it I get this alert box:
The default collation for character data in SQL Azure databases is SQL_Latin1_General_CP1_CI_AS. The server and database level collations are not configurable in SQL Azure. However, you can use a collation of your choice at the column and expression level.
I believe your problem is described here in this blog: Working With Collations In SQL Azure.
This blog article will show you how.