Your post is a bit difficult to interpret but I will summarise my understanding. If that is not correct please post back and correct my interpretation.
1. You are attempting to connect an XP laptop with a Windows 7 laptop utilising wireless networking
2. When you specify an encryption key, i.e. use WEP/WPA encryption, the laptops will not appear to be networked
3. If you remove wireless encryption the laptops network with each other OK
This could be down to the encryption method that you are using not being compatible with your Windows XP machine’s wireless networking device. WPA is not possible on some older network cards. Try WEP encryption. Research the XP laptop’s device via your preferred search engine to determine if this possibility is actually the case.
It is also possible that whichever encryption method you have chosen could be broken on one or both PCs. Re-installing drivers for the networking devices might mend this.