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answers:

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I am trying to host a Silverlight 3 Out of Browser Application in Sharepoint 2007. My application gets displayed fine; but when I install it as out of browser; and try to run it from desktop; only blank screen is displayed and nothing happens onwards.

The XAP file is kept in _layout/MyFolder/MyApp.xap (Under 12 Hive). Am I missing anything?

My Silverlight app access Sharepoint data through its web services; I need to host it within Sharepoint so that it can access underlying Sharepoint web services.

A: 

It seems likely that the ClientHTTP stack used in the OOB mode is the problem. When hosted by the browser the app will use the BrowserHTTP stack and hence would share a common set of cookies. These aren't available in OOB mode.

How for example does the initial browser access to the Sharepoint site authenticate?

Creating an OOB experience against sharepoint may be possible but its likely to require more work.

Edit: Your problem is that NTLM authentication is not supported in the ClientHTTP used in OOB mode. Silverlight-4.0 supports this mode.

AnthonyWJones
Sharepoint is using Windows Authentication (Active Directory)...the default out of box configuration.
Khurram Aziz