Not sure about your particular client. Here's what I did.
First, on the server box I enabled Remote login in the sharing preferences. Then, from the client machine I open a terminal window and enter
sftp 192.168.1.45
(this is the address of my server box on my network.)
I'm then prompted for a password and I enter it. I presume it's logging me in as the user I'm logged onto the client machine. That will work as I have the same user id on both machines.
Otherwise, I could have used
sftp userid@192.168.1.45
where userid whas some other user.
On first login, you will get a message complaining that the client is unable to verify the identity of the host and do you still want to connect (yes/no). That's because my host doesn't have a valid ssl certificate. If you answer yes, it will add the signature of that machine to the key store as "ok" and you won't be hassled from that point on. Now it's possible that your SFTP client is rejecting the connection because of this unsigned certificate. You should be able to alter the preferences for the app to allow that. However, once you've connected using the command line SFTP function and thereby added the target machine's fingerprint to your keystore, even your client should no longer app should no longer complain as you have effectively "authorized" the fingerprint.
So take out the variable of your client software and just do your first connection, connection testing using the built in SFTP command line function to connect. If you can do that, then the basic transport is configured.
I just used Dreamweaver using SFTP to connect to my remote server box and it worked.
Note: on a hunch I just tried this in the reverse direction. It DID NOT work. I got the message "received message too long" that others have reported.
Now, AFAIK, the only difference is that in this case, the target machine does NOT have the Lion Server component installed. I've got three machines to play with, a MacBook Pro and two Mac Mini's the Mini's both have Lion and Lion Server on them. The MBP does not. I can SFTP into the Mini's by just enabling remote login. This does NOT appear to be true for the MBP which is ONLY RUNNING LION. Perhaps SFTP isn't fully installed unless you are running the SERVER component. I suppose that makes sense. Are you running just LION or also LION Server?
iGeoCacher
www.ayefon.com