It isn't supported by the IDE, but it is (I believe) possible.
Meaning: I've just done it...

The painful thing is that you must (possibly with #if etc) find a way
of building the two assemblies upwards incrementally such that at each
point at least one of them builds - i.e. I compiled c1.dll with:

using System;
public class A {
}

Then I compiled c2.dll (referencing c1.dll) with:
using System;
public class B {
 A test;
}

Then I re-compiled c1.dll (referencing c2.dll) with:
using System;
public class A {
 B test;
}

Et voila; circular reference. Very painful, I'll grant - but not
impossible.
Actually, I believe that if you ask the reflection API, there is an
implied circular reference between mscorlib.dll and System.dll - but
reflector doesn't show this, so maybe this one is just the way that
reflection displays it... I believe I found this the hard way when
walking the reference tree (to force-load all libs) - it blew the
stack because of the loop.

Marc