Actually (as crazy as this sounds), this isn't a CSS error, but an HTML 
error (but only in this case; spaces on other elements are related to 
CSS).  I already reported it to the IE team yesterday.

It's documented here:  
http://www.howtocreate.co.uk/wrongWithIE/?chapter=Empty+Elements

It appears as if IE doesn't process </li> and doesn't close a list item 
until it hits either <li> or the end of the list item.  When you add a 
line break (like most of us do to make the code look better), IE 
generates a gap in the <li> where the line break is in the source.

Christian Heilmann wrote:
> Just added a workaround for the whitespace issue to the wiki, can you
> please confirm that it works for you, too?
>
> http://icant.co.uk/sandbox/whitespaceBugMSIE7.html
>
>   

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