There is one most common scenario when you will get this error.

WSS 3.0 or MOSS 2007 installed as a Basic Installation [SINGLESERVER]

By Design when you install sharepoint using Basic intallation, the Central Admin site and any other new Web Apps that you create will use 'Network Service' as the service account for the Application Pools in IIS. For a contact to be created for a Document Library, the Application Pools of both Central Admin and the Web App should be using a domain user account and not Network Service.

Steps to Perform to resolve this error.

1. Create a Service Account in Active Directory who is also a member of the Domain Admins group. Delegate all rights to this service account to the Organizational Unit created for Sharepoint, where contacts will be created.

2. On the Sharepoint server, Open Computer Management -> Local Groups and Users -> Groups. you will find 3 WSS_WPG groups, make the service account a member of all these 3 groups and also the member of the IIS_WPG group.

3. On the Sharepoint server, open IIS console and make sure that the Application pools running for Central Admin site and the Web Application are running using the service account created in step 1. Perform an IISRESET and then make sure the Central Admin and the website are up and running after changing the Application Pools.

4. Now configure the Incoming Email settings for the Document Library. You should not get the 'Error in Application' error.

5. Now create a new Web Application and a Site Collection using the service account and not 'Network Service'. Take a backup of the old Site Collection using stsadm -o backup command and restore that backup on the new one just created using stsadm -o restore

Note: We have to do the 5th step because once changing the service accounts in many cases the site will not open from Client machines, it will open only on the Server or after configuring the Incoming email settings for the Doc Library, the emails will not be visible in the document library.

These above steps will resolve the issue and also the sites up and running. In many cases where the installation is not Basic, you will find the same error message, that purely due to the service account not being a member of the 'Domain Admins' group.