It definitely looks like a settings issue.
Go to Tools -> Options, and select Playback -> Video -> DirectShow Playback Settings ...
On the resulting dialog window,
1. make sure "Use Window Media Player engine for video playback when possible" (at top left corner) is not checked;
2. make sure the file type (avi) is checked in the list on the right hand side (under "DirectShow Filters").
Then you must make sure you have DirectShow filters that can handle your files (Divx, Xvid, or whatever) - installing FFDShow (or better yet, CCCP which includes FFDShow) is the way to go.