It's possible, but not with the free version! This requires per pixel lighting (a shader). Maybe you can play around with the d3d_pointlightfalloff / d3d_spotlightfalloff variables to smooth the shadows a little. But the "blockyness" remains...
Dang . I guess I'll see if I can get it working some other way.
BTW, I (think) I have persuaded a friend of mine to purchase the pro team edition, if he gets it are there any tutorials on how to use the per pixel lighting shader?