Problem Solved (albeit in a round about manner).

After reading the comment above, I uninstalled/re-installed IE7, and the
problem was resolved -- or so I thought.

However, when I logged back on this AM, the problem was back -- all favicons
in the IE7 address drop down window had again been replaced by the generic
'E'.

WTF ????

It occurred to me that my Temporary Internet File folder (where these IE7
favicons are apparently saved) was being emptied automatically when I closed
my browser and/or rebooted my PC.

So I checked my IE Settings, but the option to "Empty Temporary Files Folder
When Browser IS Closed" was missing. See |Tools|Internet Options|Advanced
Tab|Security|

This led me to http://windowsxp.mvps.org/ie/persistent.htm which provides a
"cache.reg" fix to restore this option.

Once the registry fix was downloaded/installed, I was able to UNCHECK the
box next to "Empty Temporary Files Folder When Browser IS Closed" (which was
now visible) and the problem was resolved.

Hope this info helps someone else, since I believe I read that some folks
were experiencing a similar problem with IE8. True ????

In my travels, I also found a nice little cleanup utility called IEHistoryX
at http://www.585soft.com/iehistoryx.asp that (among other things) let's you
delete Typed URLs via a registry edit -- which means that you can cleanup the
URL entries that are displayed in the IE7 Address drop down window on a
one-by-one basis.