Just been banging my head against the wall trying to get diagramming working in Sql Server 2005 for a Sql 2000 database I restored. It turns out that I needed to run a couple of stored procs to enable this:
EXEC sp_dbcmptlevel @dbname ='<databaseName>', @new_cmptlevel = '90'
Alter database [<databaseName>] set parameterization forced
If found this info in a bigger article about upgrading the whole sql server: