OK, try this. Double click on that HOSTS file. It should ask you how you want to open it right? Don't open it yet. Instead hit ctrl+alt+del and kill the explorer.exe process. Your desktop will be blank now with no start menu. Don't worry about it. Now go back to that Open With window and open it in Notepad. Edit those lines out that MicroBell mentioned earlier. Save the file and close it. Hopefully that will allow you to do it. If not, post back.
After that's done, do a ctrl+alt+del again if the window is not up already. Then go to File->New Task and type in
explorer and hit OK. That should bring you back.
From what I read, that error by Spybot (common hijacker) is an error. So ignore it. Just do the updates weekly and run the scans.
Your log is clean. If you disabled System Restore, make sure to enable it now.
To help prevent future spyware installations/infections, please read the Anti-Spyware Tutorial
http://www.greyknight17.com/spyware.htm#prevent and use the tools provided.
Are there any problems now? If not, you should be set to go.