Many thanks for your suggestions Sebastian

However i was a little adamant about fixing the problem, more so because the problem appears in win 2003 server too, so here is the continuation:

The problem is NOT with lmhosts or hosts
With reference to www.dancechic.com the top banner in the live site appears fine, http://www.dancechic.com/portals/_default/skins/dancechic/banner2.jpg

However when i download the site to the local folder then the image stops working coz the files are now under c:\inetpub\wwwroot\DC\portals\0\....
The physical path of the folder on the server is the same, so to cheat around it on the local system I had to make a virtual directory that points to c:\inetpub\wwwroot\DC\portals\0\.... which is not the right solution, coz again if there are multiple sites I will have the same problem. I am still looking for the root cause and I think sooner or later i will find because this is the first time i am using a VPS so i am facing a lot of problems in the setup. 

One good reason that i suspect is because i had to upgrade from 4.0.2 to 5.1.2 with an intermediate upgrade to 4.9.5 which means a lot of changes. So not sure if this has something to do. Can anyone point me to where there is documentation on the rendering of the files with each call of the default.aspx?XX what events are triggered?