Are there any SQL error/info messages in the Application event log while you are deleting the smartobject.

yes, 5 logs appear in the following order

1)Event Type: Error
Event Source: SourceCode.Logging.Extension.EventLogExtension
Event Category: None
Event ID: 14011
Date:  26/10/2011
Time:  11:11:47
User:  N/A
Computer: VT-AP-01-048
Description:
14011 Error on DeleletObjectCategory, ERROR: The partner transaction manager has disabled its support for remote/network transactions. (Exception from HRESULT: 0x8004D025)    at SourceCode.Definitions.Categories.CategoriesStore.DeleteObjectsCategories(String objData, String dataTypes)
   at SourceCode.Categories.Runtime.CategoryServer.DeleteObjectCategoryData(String objData, String dataTypes)

For more information, see Help and Support Center at http://go.microsoft.com/fwlink/events.asp.

==========

2) Event Type: Error
Event Source: SourceCode.Logging.Extension.EventLogExtension
Event Category: None
Event ID: 10521
Date:  26/10/2011
Time:  11:11:47
User:  N/A
Computer: VT-AP-01-048
Description:
10521 SmartObject Runtime.Management General Error: 'The transaction has aborted.
'

For more information, see Help and Support Center at http://go.microsoft.com/fwlink/events.asp.

===========

3) Event Type: Error
Event Source: SourceCode.Logging.Extension.EventLogExtension
Event Category: None
Event ID: 2025
Date:  26/10/2011
Time:  11:11:47
User:  N/A
Computer: VT-AP-01-048
Description:
2025 Error Marshalling SourceCode.SmartObjects.Runtime.SmartObjectManagementServer.DeleteSmartObject, The transaction has aborted.

For more information, see Help and Support Center at http://go.microsoft.com/fwlink/events.asp.

=============

4) Event Type: Error
Event Source: SourceCode.Logging.Extension.EventLogExtension
Event Category: None
Event ID: 2025
Date:  26/10/2011
Time:  11:11:47
User:  N/A
Computer: VT-AP-01-048
Description:
2025 Error Marshalling SourceCode.SmartObjects.Runtime.SmartObjectManagementServer.DeleteSmartObject, The transaction has aborted.

For more information, see Help and Support Center at http://go.microsoft.com/fwlink/events.asp.

=============

5) Event Type: Error
Event Source: SourceCode.Logging.Extension.EventLogExtension
Event Category: None
Event ID: 8060
Date:  26/10/2011
Time:  11:11:47
User:  N/A
Computer: VT-AP-01-048
Description:
8060 ProcessPacket Error, The transaction has aborted.

For more information, see Help and Support Center at http://go.microsoft.com/fwlink/events.asp.
==============

The MSDTC should be configured on the K2 server as well as on the SQL server

Please configure MSDTC with "no authentication" selected. Disable the firewall service on both the mahines. Verfiy all MSDTC settings are in place as per the documentation [K2 blackpearl installation guide>before you begin > windows server 2008 config requirement>windows server 2008>MSDTC]

 my machine is running Windows Server 2003 R2, shall I use the DTC configurations given at

Installation and Configuration > Getting Started Guide > Environment Configuration > Windows Server 2003 Configuration Requirements > Enable and Configure the DTC Components

?

yes, that should be fine. MSDTC is compulsory for SmartObjects irrespective of the OS.