I found an answer to a long standing question that has been at the back of my mind today.
The problem is exactly as described in the MS Hotfix Article – KB811660
If you add files to the Offline Files folder on a Microsoft Windows XP-based computer that is shared by more than one user, offline synchronization of those files will occur when another user logs on to that computer. Network shares and Web sites that require your security credentials cannot synchronize and will prompt other users to submit the correct credentials.
This problem was fixed in WIndows XP SP3. With SP2, the hotfix is still available via the article link above.