You need to change your system "open with" type to Outlook Express.

Thanks for the update.

Unfortunately we need to open  the files  in Outlook 2003.

Any ideas?

.eml files  are used by outlook  express.
.msg are used by Outlook.

You will either need to open  it with Outlook Express or convert it to a format
that Outlook uses.

You can import an Outlook Express archive or message store into Outlook

Outlook doesn't know how to read .eml files. You would need to write a custom
plugin for outlook  or something in SharePoint that would convert the files  to a
different format.

Do you guys know at what point the file  gets converted to .eml? I'm sending the
files from outlook  2003 to the list. when i try viewing them, they seem to be
.eml. outlook won't be sending .eml files  because if it doesn't know how to
read it, it won't know how to write it right?

looking forward to hearing from you guys.

Not sure at what specific point in the process the file  becomes .eml. But you
aren't actually sending the files  from outlook. You are sending a regular
message in SMTP format. When SharePoint receives the SMTP mail it saves it in
.eml file format. Not sure why they don't use .msg (outlook format). But its
not actually converted its saved in the .eml format.

Would this help you:
http://sharepointforall.com/media/p/401.aspx

I'm now looking for a third party tool to use as a workaround for this issue.
I've looked at colligo but unfortunately it is a client side solution. Are there
any tools which you guys have used on the server to over come this problem?

There are many quality softwares in the world. But unfortunately not every program can help you. I ran into similar situation and my good luck consists in the following. I by chance caught sight next utility which resolved all my troubles for seconds. To my mind it has all necessary resources for working out almost any problem with ms outlook - http://www.recoverytoolbox.com/open_pst_files.html