No. The literal sense of being "in the sky" would mean that Allah is actually in one of His creatures, for the sky is something created. It is not permissible to believe that Allah indwells or occupies (in Arabic, "hulul") any of His creatures, as the Christians believe about Jesus, or the Hindus about their avatars.
What is obligatory for a human being to know is that Allah is "ghaniyy" or "absolutely free from need" of anything He has created. He explicitly says in surat al-Ankabut of the Qur'an, "Verily Allah is absolutely free of need of anything in the worlds" (Qur'an 29:6). Allah mentions this attribute of "ghina" or "freedom of need for anything whatsoever" in some seventeen verses in the Qur'an. It is a central point of Islamic `aqida or faith, and is the reason why it is impossible that Allah could be Jesus (upon whom be peace) or be anyone else with a body and form: because bodies need space and time, while Allah has absolutely no need for anything. This is the `aqida of the Qur'an, and Muslim scholars have kept it in view in understanding other Qur'anic verses or hadiths.
Muslims lift their hands toward the sky when they make supplications (du'a) to Allah because the sky is the qibla for du'a, not that Allah occupies that particular direction--just as the Kaaba is the qibla of the prayer (salat), without Muslims believing that Allah is in that direction. Rather, Allah in His wisdom has made the qibla a sign (ayah) of Muslim unity, just as He has made the sky the sign of His exaltedness and His infinitude, meanings which come to the heart of every believer merely by facing the sky and supplicating Allah.
It was part of the divine wisdom to incorporate these meanings into the prophetic sunna to uplift the hearts of the people who first heard them, and to direct them to the exaltedness and infinitude of Allah through the greatest and most palpable physical sign of them: the visible sky that Allah had raised above them. Many of them, especially when newly from the Jahiliyya or "pre-Islamic Period of Ignorance", were extremely close to physical, perceptible realities and had little conception of anything besides--as is attested to by their idols, which were images set up on the ground. Umar ibn al-Khattab mentions, for example, that in the Jahiliyya, they might make their idols out of dates, and if they later grew hungry, they would simply eat them. The language of the Messenger of Allah (Allah bless him and give him peace) in conveying the exaltedness of Allah Most High to such people was of course in terms they could understand without difficulty, and used the imagery of the sky above them. Imam al-Qurtubi, the famous Qur'anic exegete of the seventh/thirteenth century, says:
The hadiths on this subject are numerous, rigorously authenticated (sahih), and widely known, and indicate the exaltedness of Allah, being undeniable by anyone except an atheist or obstinate ignoramus. Their meaning is to dignify Allah and exalt Him above all that is base and low, to characterize Him by exaltedness and greatness, not by being in places, particular directions, or within limits, for these are the qualities of physical bodies (al-Jami li ahkam al-Qur'an. 20 vols. Cairo 1387/1967. Reprint (20 vols in 10). Beirut: Dar Ihya al-Turath al-Arabi, n.d.,18.216).
In this connection, a hadith has been related by Malik in his Muwatta' and by Muslim in his Sahih, that Muawiya ibn al-Hakam came to the Prophet (Allah bless him and give him peace) and told him, "I am very newly from the Jahiliyya, and now Allah has brought Islam," and he proceeded to ask about various Jahiliyya practices, until at last he said that he had slapped his slave girl, and asked if he should free her, as was obligatory if she was a believer. The Prophet (Allah bless him and give him peace) requested that she be brought, and then asked her, "Where is Allah?" and she said, "In the sky (Fi al-sama)"; whereupon he asked her, "Who am I?" and she said, "You are the Messenger of Allah"; at which he said, Free her, "for she is a believer" (Sahih Muslim, 5 vols. Cairo 1376/1956. Reprint. Beirut: Dar al-Fikr, 1403/1983, 1.382: 538). Imam Nawawi says of this hadith:
This is one of the "hadiths of the attributes," about which scholars have two positions. The first is to have faith in it without discussing its meaning, while believing of Allah Most High that "there is nothing whatsoever like unto Him" (Qur'an 42:11), and that He is exalted above having any of the attributes of His creatures. The second is to figuratively explain it in a fitting way, scholars who hold this position adducing that the point of the hadith was to test the slave girl: Was she a monotheist, who affirmed that the Creator, the Disposer, the Doer, is Allah alone and that He is the one called upon when a person making supplication (du'a) faces the sky--just as those performing the prayer (salat) face the Kaaba, since the sky is the qibla of those who supplicate, as the Kaaba is the qibla of those who perform the prayer--or was she a worshipper of the idols which they placed in front of themselves? So when she said, In the sky, it was plain that she was not an idol worshipper (Sahih Muslim bi Sharh al-Nawawi. 18 vols. Cairo 1349/1930. Reprint (18 vols. in 9). Beirut: Dar al-Fikr, 1401/1981, 5.24).
It is noteworthy that Imam Nawawi does not mention understanding the hadith literally as a possible scholarly position at all. This occasions surprise today among some Muslims, who imagine that what is at stake is the principle of accepting a single rigorously authenticated (sahih) hadith as evidence in Islamic faith (`aqida), for this hadith is such a single hadith, of those termed in Arabic ahad, or "conveyed by a single chain of transmission", as opposed to being mutawatir or "conveyed by so many chains of transmission that it is impossible it could have been forged".
Yet this is not what is at stake, because hadiths of its type are only considered acceptable as evidence by traditional scholars of Islamic `aqida if one condition can be met: that the tenet of faith mentioned in the hadith is salimun min al-muarada or "free of conflicting evidence". This condition is not met by this particular hadith for a number of reasons. First, the story described in the hadith has come to us in a number of other well-authenticated versions that vary a great deal from the "Where is Allah?--In the sky" version. One of these is related by Ibn Hibban in his Sahih with a well-authenticated (hasan) chain of transmission, in which the Prophet (Allah bless him and give him peace) asked the slave girl, "'Who is your Lord?' and she said, 'Allah'; whereupon he asked her, 'Who am I?' and she said, 'You are the Messenger of Allah'; at which he said, 'Free her, for she is a believer'" (al-Ihsan fi taqrib Sahih Ibn Hibban, 18 vols. Beirut: Muassasa al-Risala, 1408/1988, 1.419: 189).
In another version, related by Abd al-Razzaq with a rigorously authenticated (sahih) chain of transmission, the Prophet (Allah bless him and give him peace) said to her, "Do you testify that there is no god but Allah?" and she said yes. He said, "Do you testify that I am the Messenger of Allah?" and she said yes. He said, "Do you believe in resurrection after death?" and she said yes. He said, "Free her"
(al-Musannaf, 11 vols. Beirut: al-Majlis al-Ilmi, 1390/1970, 9.175: 16814).
In other versions, the slave girl cannot speak, but merely points to the sky in answer. Ibn Hajar al-Asqalani has said of the various versions of this hadith, "There is great contradiction in the wording" (Talkhis al-habir, 4 vols. in 2. Cairo: Maktaba al-Kulliyat al-Azhariyya, 1399/1979, 3.250). When a hadith has numerous conflicting versions, there is a strong possibility that it has been related merely in terms of what one or more narrators understood (riwaya bi al-ma'na), and hence one of the versions is not adequate to establish a point of `aqida.
Second, this latter consideration is especially applicable to the point in question because the Prophet (Allah bless him and give him peace) explicitly detailed the pillars of Islamic faith (iman) in a hadith related in Sahih Muslim when he answered the questions of the angel Gabriel, saying, True faith (iman) is to believe in Allah, His angels, His Books, His messengers, the Last Day, and to believe destiny (qadr), its good and evil (Sahih Muslim, 1.37: 8)--and he did not mention anything about Allah being "in the sky". If it had been the decisive test of a Muslims belief or unbelief (as in the "in the sky" hadith seems to imply), it would have been obligatory for the Prophet (Allah bless him and give him peace) to mention it in this hadith, the whole point of which is to say precisely what "iman is".
Third, if one takes the hadith as meaning that Allah is literally "in the sky", it conflicts with other equally sahih hadiths that have presumably equal right to be taken literally--such as the hadith qudsi related by al-Hakim that Allah Most High says, "I am with My servant when he makes remembrance of Me and his lips move with Me" (al-Mustadrak ala al-Sahihayn. 4 vols. Hyderabad, 1334/1916. Reprint (with index vol. 5). Beirut: Dar al-Marifa, n.d., 1.496), a hadith that al-Hakim said was rigorously authenticated (sahih), which al-Dhahabi confirmed. Or such as the hadith related by al-Nasai, Abu Dawud, and Muslim that "the closest a servant is to his Lord is while prostrating" (Sahih Muslim, 1.350: 482)--whereas if Allah were literally "in the sky", the closest one would be to Him would be while standing upright. Or such as the hadith related by al-Bukhari in his Sahih, in which the Prophet (Allah bless him and give him peace) forbade spitting during prayer ahead of one, because when a person prays, "his Lord is in front of him" (Sahih al-Bukhari, 1.112: 406). Finally, in the hadiths of the Mir'aj or "Nocturnal Ascent", the Prophet (Allah bless him and give him peace) was shown all of the seven heavens (samawat) by Gabriel, and Allah was not mentioned as being in any of them.
Fourth, the literal interpretation of Allah being "in the sky" contradicts two fundamentals of Islamic `aqida established by the Qur'an. The first of these is Allah's attribute of mukhalafa li al-hawadith or "not resembling created things in any way", as Allah says in surat al-Shura, "There is nothing whatsoever like unto Him" (Qur'an 42:11), whereas if He were literally "in the sky", there would be innumerable things like unto Him in such respects as having altitude, position, direction, and so forth. The second fundamental that it contradicts, as mentioned above, is Allahs attribute of ghina or "being absolutely free of need for anything created" that He affirms in numerous verses in the Qur'an. It is impossible that Allah could be a corporeal entity because bodies need space and time, while Allah has absolutely no need for anything.
Fifth, the literalist interpretation of "in the sky" entails that the sky encompasses Allah on all sides, such that He would be smaller than it, and it would thus be greater than Allah, which is patently false.
For these reasons and others, Islamic scholars have viewed it obligatory to figuratively interpret the above hadith and other texts containing similar figures of speech, in ways consonant with how the Arabic language is used. Consider the Qur'anic verse "Do you feel safe that He who is in the sky will not make the earth swallow you while it quakes" (Qur'an 67:16), for which the following examples of traditional tafsir or "Qur'anic commentary" can be offered:
(al-Qurtubi:) The more exacting scholars hold that it ["in the sky"] means, "Do you feel secure from Him who is over the sky"--just as Allah says, "Journey in the earth" (Qur'an 9:2), meaning journey over it--not over the sky by way of physical contact or spatialization, but by way of omnipotent power and control. Another position is that it means "Do you feel secure from Him who is over ('ala) the sky," just as it is said, "So-and-so is over Iraq and the Hijaz", meaning that he is the governor and commander of them (al-Jami li ahkam al-Qur'an, 18.216).
(al-Shirbini al-Khatib:) There are various interpretive aspects to "He who is in the sky," one of which is that it means "He whose dominion is in the sky," because it is the dwelling place of the angels, and there are His Throne, His Kursi, the Guarded Tablet; and from it are made to descend His decrees, His Books, His commands, and His prohibitions. A second interpretive possibility is that "He who is in the sky" omits the first term of an ascriptive construction (idafa)--in other words, "Do you feel safe from the Creator of him who is in the sky"; meaning the angels who dwell in the sky, for they are the ones who are commanded to dispense the divine mercy or divine vengeance (al-Siraj al-Munir. 4 vols. Bulaq 1285/1886. Reprint. Beirut: Dar al-Marifa, n.d., 4.344).
(Fakhr al-Din al-Razi:) "He who is in the sky" may mean the angel who is authorized to inflict divine punishments; that is, Gabriel (upon whom be peace); the words "cause the earth to swallow you" meaning "by Allahs command and leave" (Tafsir al-Fakhr al-Razi. 32 vols. Beirut 1401/1981. Reprint (32 vols. in 16). Beirut: Dar al-Fikr, 1405/1985, 30.70).
(Abu Hayyan al-Nahwi:) Or the context of these words may be according to the convictions of those being addressed [the unbelievers], for they were anthropomorphists. So that the meaning would be, "Do you feel safe from Him whom you claim is in the sky?--while He is exalted above all place" (Tafsir al-nahr al-madd min al-Bahr al-muhit. 2 vols. in 3. Beirut: Dar al-Janan and Muassasa al-Kutub al-Thaqafiyya, 1407/1987, 2.1132).
(Qadi Iyad:) There is no disagreement among Muslims, one and all--their legal scholars, their hadith scholars, their scholars of theology, both those of them capable of expert scholarly reasoning and those who merely follow the scholarship of others--that the textual evidences that mention Allah Most High being "in the sky", such as His words, "Do you feel safe that He who is in the sky will not make the earth swallow you," and so forth, are not as their literal sense (dhahir) seems to imply, but rather, all scholars interpret them in other than their ostensive sense (Sahih Muslim bi Sharh al-Nawawi, 5.24).
We now turn to a final example, the hadith related by Muslim that the Prophet (Allah bless him and give him peace) said:
Your Lord Blessed and Exalted descends each night to the sky of this world, when the last third of the night remains, and says: "Who supplicates Me, that I may answer him? Who asks Me, that I may give to him? Who seeks My forgiveness, that I may forgive him?" (Sahih Muslim, 1.521: 758).
This hadith, if we reflect for a moment, is not about `aqida, but rather has a quite practical point to establish; namely, that we are supposed to do something in the last third of the night, to rise and pray. This is why Imam al-Nawawi, when he gave the present chapter names to the headings of Sahih Muslim, put this hadith under "Instilling Desire to Supplicate and Make Remembrance of Allah (Dhikr) in the Last of the Night, and the Answering Therein". As for the meaning of "descends" in the hadith, al-Nawawi says:
This is one of the "hadiths of the Attributes", and there are two positions about it, as previously mentioned in the "Book of Iman". To summarize, the first position, which is the school of the majority of early Muslims and some theologians, is that one should believe that the hadith is true in a way befitting Allah Most High, while the literal meaning of it as known to us and applicable to ourselves is not what is intended, without discussing the figurative meaning, though we believe that Allah is transcendently above all attributes of createdness, of change of position, of motion, and all other attributes of created things.
The second position, the school of most theologians, of whole groups of the early Muslims (salaf), and reported from Malik and al-Awzai, is that such hadiths should be figuratively interpreted in a way appropriate to them in their contexts. According to this school of thought, they interpret the hadith in two ways. The first is the interpretation of Malik ibn Anas and others, that it ["your Lord descends"] means "His mercy, command, and angels descend," just as it is said, "The sultan did such-and-such," when his followers did it at his command. The second is that it is a metaphor signifying [Allah's] concern for those making supplication, by answering them and kindness toward them (Sahih Muslim bi Sharh al-Nawawi, 6.3637).
The hadith scholar Ali al-Qari says about the above hadith of Allah's "descending":
You know that Malik and al-Awazai, who are among the greatest of the early Muslims, both gave detailed figurative interpretations to the hadith....Another of them was Jafar al-Sadiq. Indeed a whole group of them [the early Muslims], as well as later scholars, said that whoever believes Allah to be in a particular physical direction is an unbeliever, as al-Iraqi has explicitly stated, saying that this was the position of Abu Hanifa, Malik, al-Shafi'i, al-Ashari, and al-Baqillani (Mirqat al-mafatih: sharh Mishkat al-masabih. 5 vols. Cairo 1309/1892. Reprint. Beirut: Dar Ihya al-Turath al-Arabi, n.d., 2.137).
It is worth remembering that al-Iraqi was a hafiz or "hadith master", someone with over 100,000 hadiths by memory, while Ali al-Qari was a hadith authority who produced reference works still in use today on forged hadiths. In other words, each had the highest credentials for verifying the chains of transmission of the positions they relate. For this reason, their transmission of the position of the unbelief of whoever ascribes a direction to Allah carries its weight.
But perhaps it is fitter today to say that Muslims who believe that Allah is somehow "up there" are not unbelievers. For they have the shubha or "extenuating circumstance" that moneyed quarters in our times are aggressively pushing the bid'a of anthropomorphism. This bid'a was confined in previous centuries to a small handful of Hanbalis, who were rebutted time and again by ulama of Ahl al-Sunna like Abd al-Rahman ibn al-Jawzi (d. 597/1201), who addressed his fellow Hanbalis in his Daf shubah al-tashbih bi akaff al-tanzih [Rebuttal of the insinuations of anthropomorphism at the hands of divine transcendence] with the words:
If you had said, "We but read the hadiths and remain silent," no one would have condemned you. What is shameful is that you interpret them literally. Do not surrreptiously introduce into the madhhab of this righteous, early Muslim man [Ahmad ibn Hanbal] that which is not of it. You have clothed this madhhab in shameful disgrace, until it can hardly be said "Hanbali" any more without saying anthropomorphist (Daf shubah al-tashbih bi akaff al-tanzih. Cairo n.d. Reprint. Cairo: al-Maktaba al-Tawfiqiyya, 1396/1976, 2829).
These beliefs apparently survived for some centuries in Khorasan, Afghanistan, and elsewhere in the East, for Imam al-Kawthari notes that the Hanbali Ibn Taymiya (d.728/1328) picked up the details of them from manuscripts on sects (nihal) when the libraries of scholars poured into Damascus with caravans fleeing from the Mongols farther east. He read them without a perspicacious teacher to guide him, came to believe what he understood from them, and went on to become an advocate for them in his own works (al-Kawthari, al-Sayf al-saqil fi al-radd ala Ibn Zafil. Cairo 1356/ 1937. Reprint. Cairo: Maktaba al-Zahran, n.d. 56).
He was imprisoned for these ideas numerous times before his death, the ulama of Damascus accusing him of anthropomorphism (al-Asqalani, al-Durar al-kamina fi ayan al-mia al-thamina. 4 vols. Hyderabad 134950/193031. Reprint. Beirut: Dar Ihya al-Turath al-Arabi, n.d., 1.155).
Writings were authored by scholars like Abu Hayyan al-Nahwi (d.745/1344), Taqi al-Din Subki (d.756/1355), Badr al-Din ibn Jama'a (d.733/1333), al-Amir al-Sanani, author of Subul al-salam (d.1182/1768), Taqi al-Din al-Hisni, author of Kifayat al-akhyar, (d.829/1426), and Ibn Hajar al-Haytami (d.974/1567) in rebuttal of his `aqida, and it remained without acceptance by Muslims for another four hundred years, until the eighteenth-century Wahhabi movement, which followed Ibn Taymiya on points of `aqida, and made him its "Sheikh of Islam." But was not until with the advent of printing in the Arab world that Ibn Taymiya's books (and the tenets of this sect) really saw the light of day, when a wealthy merchant from Jedda commissioned the printing of his Minhaj al-sunna and other works on `aqida in Egypt at the end of the last century, resurrected this time as Salafism or "return to early Islam." They have since been carried to all parts of the Islamic world, borne upon a flood of copious funding from one or two modern Muslim countries, whose efforts have filled mosques with books, pamphlets, and young men who push these ideas and even ascribe them (with Ibn Taymiya's questionable chains of transmission, or none at all) to the Imams of the earliest Muslims. My point, as regards considering Muslims believers or unbelievers, is that this kind of money can buy the influence and propaganda that turn night into day; so perhaps contemporary Muslims have some excuse for these ideas--until they have had a chance to learn that the God of Islam is transcendently above being a large man, just as He is transcendently above being subject to time or to space, which are but two of His creatures.
To summarize what I have said in answer to the question above, scholars take the primary texts of the Qur'an and sunna literally unless there is some cogent reason for them not to. In the case of Allah "descending" or being "in the sky", there are many such reasons. First, a literal interpretation of these texts makes it impossible to join between them and the many other rigorously authenticated texts about Allah being "with" a servant when he does dhikr, "closer to him than the jugular vein" (Qur'an 50:16), "in front of him" when he prays, "closest" to him when he is prostrating, "in the sky" when a slave girl was asked; "with you wherever you are" (Qur'an 58:4), and so on. These are incoherent when taken together literally, and only become free of contradictions when they are understood figuratively, as Malik, al-Awzai, and al-Nawawi have done above. Second, the Prophet (Allah bless him and give him peace) detailed the beliefs that every Muslim must have in the Gabriel Hadith in Sahih Muslim and others, and did not mention Allah being "in the sky" (or anywhere else) in any of them. Third, Allah's being "in the sky" as birds, clouds, and so on are in the sky in a literal sense contradicts the `aqida of the Qur'an that there is "nothing whatsoever like unto Him" (Qur'an 42:11). Fourth, the notion of Allahs being in particular places contradicts the `aqida expressed in seventeen verses of the Qur'an that Allah is free of need of anything, while things that occupy places need both space and time.
These reasons are not exhaustive, but are intended to answer your question by illustrating the `aqida and principles of traditional ulama in interpreting the kind of texts we are talking about. They show just how far from traditional Islam is the belief that Allah is "in the sky" in a literal sense, and why it is not permissible for any Muslim to believe this. And Allah alone gives success.