I am having the same problem with my Sony PRS-650. I am on a Mac (Intel iMac, OS 10.7.2), but like you I also have the most recent versions of ADE, Sony Reader software, and Calibre. Both my computer and device are authorized with both ADE and the Sony Reader Store.
I too borrowed an ebook from my local library via Overdrive. I followed the instructions in
Calibre Help to transfer it to my device
*, but I get the same error message you do.
I also installed the most recent release of Sony's software (simply called
Reader, v1.1.04.11231). Even though Sony says it also works for my model, I suspect it was mainly meant for the new WiFi PRS-T1 readers. (Before the PRS-T1 models, the software for Sony devices was called
Reader Library, v3.3.00.07130.)
Maybe other PRS-T1 users or the Calibre people could tell us if the presence of this latest Sony Reader software somehow interferes with borrowed library books on the device.
* per Calibre Help:- I opened the downloaded acsm file with ADE.
- ADE downloaded the actual epub book into "My Digital Editions" folder.
- I brought the epub from there into my Calibre library. In Calibre, I transferred the epub to my device.
- When I went to read it on my device, the screen showed the Protected by Digital Rights Management error message.
I also returned the ebook (and completely deleted it from my computer and from my Reader) and re-borrowed it. I then tried opening the acsm file in Sony Reader instead of in ADE. (Like ADE, Sony Reader downloads the epub, only into a different location.) Ended up with the same result.