In the long run I recommend using a Linux machine to compile kernel and applications.
The advantage is:
1) you can use initramfs and zImage
2) you dont have to deal with broken Cygwin installations
3) The Eclipse is difficult to update, once a new Quartus version comes out.
Right now hippo is working on the new uClinux-dist with 2.6.17 kernel.
I only tried out the buildroot approach with the Microtronix port, this works well but the kernel is 2.6.11 which is sometimes a problem when adding drivers.
Be careful with the installation of Cygwin. No Cygwin other than Altera's is allowed on the system.
Make sure that the path variable points to the right locations. Check the path variable in Environment variables.
Furthermore check the variables: QESS_ROOTDIR, QUARTUS_ROOTDIR, SOPC_BUILDER_PATH_50 and SOPC_KIT_NIOS2, they all have to point to the 5.0 version.
Fix the path in configure.bat (for example:
c:\altera\kits\nios2_50\bin\eclipse\workspace\<projectname>\configure.bat)
hope this might help