From the Selenium FAQ, Selenium apparently works with some types of dialogs but not others:
I can't interact with a popup dialog.
My test stops in its tracks!
You can, but only if the dialog is an
alert or confirmation dialog. Other
special dialogs can't be dismissed by
javascript, and thus currently cannot
be interacted with. These include the
"Save File", "Remember this Password"
(Firefox), and modal (IE) dialogs.
When they appear, Selenium can only
wring its hands in despair.
To solve this issue, you may use a
workaround (if one exists); otherwise
you may have to exclude the test from
your automated corpus. For the "Save
File" dialog in Firefox, a custom
template may be specified when running
via the RC that will always cause the
file to be downloaded to a specified
location, without querying the user
(see
http://forums.openqa.org/thread.jspa?messageID=31350).
The "Remember this Password" dialog
should not appear again after you've
chosen to remember it. Currently there
is not much that can be done about IE
modal dialogs.
I seem to remember someone working around this with an AutoHotKey script that dismissed the dialog.