Ok, I've your problem has sucked me in. 1st it's not a simple problem. Don't feel bad. 2nd I haven't really nailed down EXACTLY what's causing it. I'm 99% sure it's a funky Windows registry setting, but which one brings us back to the needle and that damned haystack.
Fortunately, all of the settings "Windows Explorer" uses are all sitting in one lump in the registry. "Windows Explorer" by the way it the desktop, my computer, the start menu and all taht happy horse crap. It's basically the user interface. This part of Windows has changed drastically from Windows 98 SE to XP. Fixes for XP hence won't help.
Anyway, explorer's settings are stored in:
HKEY_CURRENT_USER \ Software \ Microsoft \ Windows \ CurrentVersion \ Explorer
As long as you're careful and make a backup, you should be able to play with this part of the registry and maybe get things back in order.
First, how to back this up.
Click start -> run -> regedit
browse to the above location I posted
In the left pane, click on the yellow folder that says "explorer" (last folder you opened)
now from the menus, choose registry -> Export Registry File
Make sure it says "Selected Branch"
Next save it as a .reg file someplace on your hard drive. Just be sure you know where you put it and what you called it.
Now, I have a vmware Windows 98 SE machine that DOES NOT have this problem. I did the above process and produced a .reg file for you to try. It's called: explorer-settings-win98.reg To use this file, you only have double click it. Windows should ask you if you want to import some settings or something. Say yes. Restart.
If this doesn't solve the problem, 1) I'm mistified but 2) you need to get your stuff back the way it was. Just go find your backup .reg file and double click it to insert it into the registry. Restart again of course.
I've also included a really small file: auto-arrange-icons-off-win98.reg This just plays with the auto arrange part of the registry. My gut tells me this isn't going to work. It's the less scary of the two though. Maybe try this one first.
You can look at these .reg files in notepad if you're curious what they are made of. (right click one and hit edit works real slick to see the contents).