I had exactly the same problem with my ATI 1600 not being recognized on my iMac Late 2006.
I went to ati.com and downloaded the 1600 (generic Microsoft) driver. I then deleted the standard vga driver. Restarted Windows 7 and used the new driver even though it said I shouldn't. Worked fine and my graphics score went from 1.0 to 4.2 and I could now get the proper screen resolution. Aero and games now work great.
Another Windows restart told me the ATI driver needed to be updated. I did so and it then it installed the proper Radeon 1600 mobility driver. No restart was required after this update.
All is now well, video, sound, iSight, etc.
Hope this helps you.
John