I was able to accomplish something similar using the "Text File Changes" section found in the "System Configuration" area in InstallShield installation Designer.
Since your application setting is found in the app.config file, you can set up the text file changes to look for a specific string such as "MyServer" and replace it with whatever the user selects at install time for their sql server. (You will need a sql connection entry under "SQL Scripts" for the user to see the sql server connection dialog at install time).
This question is 3 months old at the time of this answer; maybe it will help someone else with this same issue...