Re: http://USER1.domain.com not working at all!
First ,you are saying that it is a directory install ,which is not correct as you are mentioning that you made sure ,the blogs get address like user.yoursite.com [It is called subdomain style]
Now for this to work, you need to configure your wildcard DNS and sub domains.
If you on a capanel it is very easy.Login to cpanel,create a subdomain *,like say *.yoursite.com and go and check again ,the blog should be working now.
Hope it helps.