Hmm, that is strange.
The avr binaries (avr-gcc, etc.) rely on some DLLs provided by cygwin. I'm guessing that you have similar but incompatible versions of the DLLs somewhere and that those are being used instead of the ones that come with Arduino. What happens if you cd to c:\arduino-0008 and run tools\avr\bin\avr-gcc (the cygwin DLLs are in the root Arduino directory, so you should be there when you run avr-gcc)? Do you have WinAVR installed? Can you search for cygwin1.dll in your windows directory (or a subdirectory of it)?
I am having a similar problem using 0009 on vista. When I run the compile from the command line, this is what I get:
C:\Util\arduino\arduino-0009>C:\Util\arduino\arduino-0009\tools/avr/bin/avr-gcc
-c -g -Os -IC:\Util\arduino\arduino-0009\lib\targets\arduino -w -mmcu=atmega168
-DF_CPU=16000000L C:\Util\arduino\arduino-0009\lib\targets\arduino\pins_arduino
c -oc:\Util\arduino\arduino-0009\examples\Digital\Blink\applet\pins_arduino.c.o
Assembler messages:
Can't open /cygdrive/c/Users/shiblaj/AppData/Local/Temp/ccsfeOdE.s for reading:
No such file or directory