(chances are good that either the ShellIconCache file is damaged or the icon cache is too small)

Repairing corrupted desktop icons

If your desktop icons have become corrupted, you may be able to correct the problem by deleting ShellIconCache from your Windows directory. To do this, carry out the following steps:

1. Open Folder Options in Control Panel. If you do not see the Folder Options icon, click view all Control Panel options.
2. Click the View tab, and then select Show hidden files and folders.
3. Click Start, point to Programs, point to Accessories, and then click MS-DOS Prompt.
4. Type the following commands, pressing ENTER after each command:
   del shelliconcache
   exit
5. Restart your computer.
6. When you reboot Windows, the ShellIconCache will be recreated and your icons should be back to normal.

Increasing the size of the icon cache

1. START; Run; Type "RegEdit" & Enter
2. Clicking the plus (+) signs in the left pane starting at "HKEY_LOCAL_MACHINE" and  ending at "CurrentVersion".
3. Finally, click the key "explorer" in the left pane (not it's plus sign).
4. In the right pane, R-Clk an empty area; point to "new"; select "string value"; type or paste "Max Cached Icons" & Enter.
5. R-Clk "Max Cached Icons"; select "Modify"; enter "2048" & click OK.  ( you may be able to increase this value to as high as 8192)
6. Close RegEdit & reboot.

Other Options

I have discovered in Windows ME that deleting the shelliconcache file and increasing the icon cache value may only be a temporary fix. The final solution came in going to
Display Properties>Effects tab and removing the check in "Show icons using all possible colors".

You could also download  the icon repair file from
http://www.aumha.org/regfiles.php#icons