Hi Bob,
I changed the theme as well as master page to be default and still I face the same issue. The other intersting thing is that I can create the folder in Document library in the same site and it works like charm. However, the list folders still give me the problem.
Other point is, I am running MOSS 2007 SP1 and without infrastructure update. I tested the same in 4 different environments running on MOSS 2007 SP1 WITHOUT infrastructure update and got the same result.
Any thoughts?