Out of the box, pppd doesn't support shadow passwords when configured for dialup server. Rebuilding the src.rpm with shadow support cures this problem. However an interim fix at the customers site was to disable shadow passwords, since this was a non network connected box. However, once the passwords were disabled we were unable to set passwords for a new user. Go figure. :)
pppd is compiled with support for pluggable authentication modules, which supports shadow passwords as a configuration option. What are the contents of your /etc/pam.d/ppp file?
Bug 9971 has been closed because no additional information was given by original bug reporter since Year 2000.