Custom permalink 404 error

Hi,

I have a fairly commonly experienced issue where my custom permalink results in 404 errors for posts, categories and archive links. I have scoured the support forums and the Internet for fixes and tried lots of things but none of them have worked.

I have installed WordPress to a folder called blog and have a 301 redirect from the main URL.

If I use the default permalink setting everything works. When I use the setting “/%postname%/”, it does not work (or any other non-default permalink setting, in fact).

I have disabled all the plugins (was just using WPTouch) to no avail.
I have also removed the .htaccess file, allowed it to be regenerated automatically and tested it but that resulted in 404 errors as well.

This is my current .htaccess file:

RewriteEngine on

# BEGIN WordPress
<IfModule mod_rewrite.c>
RewriteEngine On
RewriteBase /
RewriteRule ^index\.php$ - [L]
RewriteCond %{REQUEST_FILENAME} !-f
RewriteCond %{REQUEST_FILENAME} !-d
RewriteRule . /index.php [L]
</IfModule>

# END WordPress
RewriteCond %{HTTP_HOST} ^.*$
RewriteRule ^/?$ "http\:\/\/www\.mydomain\.com\/blog\/" [R=301,L]

RedirectMatch 301 ^/([0-9]+)/([0-9]+)/([0-9]+)/(.*)$ http://www.mydomain.com/$4

I have also tried commenting out the RedirectMatch 301 line in case that had an effect.

What can I do to fix this permalink issue?

Thank you for your time.
Jon