pretty permalinks & .htaccess aren’t working

i’ve created a .htaccess file and put in wordpress’ recommended code, but it doesn’t work. i put the .htaccess file under the wp-content/themes/royalty-theme/ – i would presume this is the correct place. i’ve had no problems renaming the file so that it has the “dot” and doesn’t have the “.txt” extension. i’ve had no problems setting up the permissions to 660, 666, 777, and the like. (i’m using Core FTP LE, connecting via sftp.) i’ve verified with my hosting service they they do support .htaccess files. i also tried adding an httpd.config file to allow override. all of the results are the same: when i mouseover links on the homepage, i can see the url as the pretty-permalink in the lower left hand side of the screen, but when i click the link i get an error page.

so am i stuck with the default ugly permalinks forever? help?