Interesting... If I enable "Auto-register new users?" I can log in.
If I turn it off, I get the expected "ERROR: <username> is not registered with this blog."
When this plugin is enabled, if I try to add a new user, I get "ERROR: Please enter your password.", since the password fields are missing from the add user page.
If I deactivate the plugin, add a new user, enable the plugin, and try to log in as that user, I get what I described previously: WordPress login page with "ERROR: The password you entered for the username <username> is incorrect."
So part of this clearly works, but the way I was hoping to use it doesn't work for me.