I understand why you are confused by that message. A 169.254.x.x IP address is called an Automatic Private IP Address (APIPA) and it's standard practice when you are configured for DHCP but are unable to get an IP address from your DHCP server, or there is no DHCP server by design.
The problem is, this message is coming from a part of Windows that doesn't know anything about the wireless connection process. This module, whatever it is, has given up on trying to get a DHCP assignment, but it doesn't know it is because the wireless connection protocol has failed (due to a bad key or other configuration error).
The Windows wireless module is absolutely silent. Some laptop vendors have tried, with limited success, to replace the Windows silence with better tools, but the integration leaves a lot to be desired and that stupid yellow ball continues to roll back and forth, confusing everyone.
Windows 7 seems to work better. Ubuntu is better. XP never will be fixed. Just assume that your wireless access protocol is set incorrectly or, more likely, the key is mis-typed, or needs to be entered again. Then wait for Windows 7. :-)