The message "System error" is coming from PAM.

My first guess is that you have a misconfiguration on your system, but
this could also be a PAM bug.

Can you check you /var/log/auth.log for messages from PAM?
Can you provide you PAM configuration?
(/etc/pam.d/passwd and the files linked from there)

** Package changed: shadow (Ubuntu) => pam (Ubuntu)

-- 
passwd - can't login, change password
https://bugs.launchpad.net/bugs/546874
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