Anyone struggling with this situation... I finally found an answer!
check out ArjunTA's answer!
I'll copy it here in case that thread gets deleted:
Hi Everyone,
There has been a lot of back and forth on this topic. I faced a similar problem and this is a summary of my experience and the solution I used.
1) If you are facing this problem, you are probably trying to configure your hotmail id onto Ipad, Iphone or some such device.
2) You are going to face this problem if you have enabled "Two Step Verification". In my opinion Two Step Verification is good coz it provides better security to your account. When TSV is turned on, I am guessing the server is expecting two passwords, one is your regular password and the other is the second code as part of "Two Step Verification". Since you are able to enter only one password when trying to set up your account, it keeps failing and gives this error.
3) If you think you have not enabled Two step verification, you might have enabled it and since you have been using a trusted device till date you have never had to use the two step verification system and thus forgotten about it.
Good link to check:
http://windows.microsoft.com/en-us/windows/two-step-verification-faq
How to check if Two Step verification (TSV) is turned on for your account:
4) How to see if you have two step verification turned on is given in above link but summary, log in to your mail or account. In your mail top right you will see your name, click on it, you should see options such as available, invisible, edit profile, account settings and logout.
5) Click on account settings. New page opens, re-verify your password. Under security and privacy you should see "Manage advanced security". Click on it
6) Scroll down till you see:
Two-step verification
Your account is protected by two-step verification.
Turn off two-step verification
(this means TSV is on - if you want to disable it, click on the link given there to Turn Off and follow steps)
How to configure my mail without turning off Two step verification (TSV)
8) I configured my hotmail onto my ipad without turning off TSV. This is what i did
9) Once you have reached "Manage advanced security" and clicked on it you should scroll down till you see
App passwords
10) There you will find "Create a new app password" or "Create app password". Click on it and it will display a password on screen.
11) This is the password you need to enter when you are trying to set up your mail account on your device. Dont enter your regular password.
12) This is a one time exercise to configure your mail. Once done you dont have to enter this password on that device again.
Hope this helps.
NOTE: It helps if you do the above exercise on a computer (PC) while having your Ipad, Iphone or tablet handy so that at the final step you can see the PC screen and enter the code into the hand held device.
