That's a strange one and I haven't seen that behavior.  I have this all working now on several sites that I've upgraded to .NET 3.5 (some with SP1, others not).  What I have found to be the "best" procedure is to replace all references in the web.config pointed to the 1.0.61025.0 to 3.5.0.0 AND for good measure, add the assemblyBinding section to the bottom of the web.config (runtime section) to make it so any DLL hard-linked to the older assembly will automatically "roll-up" to use the newer assembly.  Additionally you need to remove the System.Web.Extensions.dll from your BIN as the 3.5 is GAC'd as part of the .NET framework (whereas the AJAX stuff in 2.0 was an "add-on").

I have found that, in general, ASP.NET 3.5 AJAX performs much better than the 2.0 counterpart.  With no other changes I saw at least a 20% increase in speed on some modules using UpdatePanels.  I have since rewritten some logic on those modules to increase the speed over 30 times as fast (query optimizations, some code optimizations, and moving to SQL 2005 from SQL 2000).