Although I think that season five was most pivotal for her character, I think in season seven both Dawn and Michelle really sparkelled.
She was given so much more personality, really developed as a character in her own right, not just as Buffy's little sister.
Also, did anyone else LOVE Potential? That scene between Xander and Dawn really made me cry (granted I was really emotional when I first saw it), it was so beautiful, and Michelle was wonderful.