I have a website running on .NET 2.0 right now.
I have a reporting tool which needs to run on the same webserver as well, but it was written in 3.5.
Can I create a Virtual Directory under websites, called "Reports" and have that run against 3.5? So the user can go to http://domain/Reports ?
Let me know if this makes no sense.
Absolutely. .NET 3.5 is primarily an added set of libraries over a service-packed version of the existing 2.0 runtime. As long as you've deployed 3.5 completely (and service packed it as well, while we're at it), you should be fine.
While there are new language features galore in the newest version of Visual Studio (eg, C# 3.0), these are artifacts of the compiler. All your 3.5 apps will run, as far as IIS settings are concerned, in the 2.0 virtual directories/applications/app pools.