I would test the limit theory by renaming the hosts file and then opening this renamed file and then copying and pasting say half the entries into a newly created hosts file. See if it works with this size, if not then I'd cut the entries in half again until it works.
Then I would add some more say 100~200 entries until I reach the non-functional threshold.
One thing I've noticed with 2k over XP is that I usually have to logoff from the local machine and log back on again even after making one change to the hosts file, not sure why that is but since upgrading my workstation to XP this is no longer neccessary.

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