This was my issue although I had stsadm setapppassword and peoplepicker-searchadforests setup correctly.
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On the “HKLM\Software\Microsoft\Shared Tools\Web Server Extensions\14.0\Secure” registry key ensure the following permissions are in place and are being inherited in the sub-keys
* WSS_WPG Read permission
* WSS_Admin_WPG Full Control
* WSS_RESTRICTED_WPG_V4 Full Control
Reference:
http://blogs.msdn.com/b/sofocle/archive/2011/05/17/sharepoint-2010-people-picker-issue-quot-there-was-an-error-in-the-callback-quot.aspx
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