When you’re hosting Silverlight, you have to tweak your IIS settings to allow the server to know how to handle the extensions that it’s not familiar with.

In IIS you have to add these MIME types.

.xaml application/xaml+xml
.xap application/x-silverlight-app
.xbap application/x-ms-xbap

To add the MIME types to IIS6:

1. Choose the Virtual Directory or Default Web Site in IIS
2. Open the context menu and choose “Properties”
3. Select the “HTTP-Headers” tab
4. Click the button labeled “File Types…” in MIME Map section
5. Choose “New Type” and type the extension from above into the extension field and the application type into the MIME type field.
6. After adding all 3, click “OK” then click “Apply” on the main menu. You’re done. No restart needed.

In more recent versions of IIS, process is little different, but I am sure you got the idea how to do it.

From Webcosmo Webmaster Forum http://www.webcosmoforums.com/asp/21242-unhandled-error-silverlight-application-code-2104-category-initialize-silverlight-iis.html