I have tried to do this with mail merge by following the instructions on the
dialog box but it will not work. It accepts all the instuctions, creates a
document but the "merge" button is always greyed out. When I open the
document it just has the words "next record" for every label.
You failed to post your versions.
You failed to post what steps you were following.
If I can hazard a guess at those things, I'd bet you are failing to use the
"Propagate labels" step.
In Outlook/Word 2002/2003 there is an extra step required to create mailing
labels. Instructions here: http://support.microsoft.com/?kbid=284401