The circuit is wired per the diagram you posted with the exception that AREF of the breadboard arduino is tied to the breadboard power rail (Duemilanove 5V). I tried the procedure you outlined below with the AREF disconnected the bootloader burned correctly! I re-burned the bootloader a second time to rule out any flukes and the second attempt was successful as well.
But, I tried to burn the bootloader a third time with the Duemilanove 3.3V supply connected to the AREF of the target board, and I got the same error message as before, but it was listed 4 times instead of just once. I tried burning the bootloader a several times after this with the AREF disconnected and all attempts were unsucessful. 
Not sure what this means.
*Correction to my stated setup, the resistor placed between the reset and 5 volt pins on the Duemilanove is a 120 ohm resistor. I measured its resistance to be 118.7 ohms.