Yep! What you are describing is the "classic" symptom of trying to log into the shell with a user that is an "ftp only" user (not authorized shell access).
Go to Control Panel -> Users -> Manage Users, select the "Edit" link adjacent to the user you are having trouble with, and make sure that the radio button for "shell" is selected. Submit the form, and wait for it to take effect (usually a matter of a few minutes).
Once the change has taken effect, you should be able to telnet (though, please do not use telnet, as it is insecure) or ssh into the shell without problem (assuming the user/pass is correct).