Several people have contacted me about this problem and I have been able to resolve the issue.
I posted version 1.2.0.1 of The Magic Folder gadget and it is now live on the Vista Gadget Gallery site.
If you still get the error, you will need to delete the bad settings file. To do this follow these steps:
1) Click Start, then type %AppData%.
2) Open the following folders: Microsoft. windows sidebar, TheMagicFolder.Gadget
3) Delete the file: Settings.dat.
4) Restart the gadget and you are good to go.
Please send me an e-mail if you continue to have any issues: davidcr_msft@hotmail.com.