Downgrading video drivers didnt work, but running Windows Media Player while playing has fixed all my problems. Fairly strange solution, but anyway, it works...
I'm having a similar problem, but it only affects me when I'm trying to hotlap... single player works fine, and in multiplayer, I race ok for 3-4 seconds, then lag for 1 second, then race for 3-4 seconds, then lag, and it just remains like that then entire time I'm in a server, yet I can go play CS or whatever and the connection is perfect.
My pc is AMD64 3000+, 512mb pc3200, 256mb 6600GT, 2x WDC 120gb.
The game was working fine until I bought the new video card a week or so ago, but afaik, I was running the 78.01's with my old card as well and it never seemed to have a problem, and all my other games are running heaps better with the new card so it would appear to be something LFS-specific...
I'll try downgrading my drivers tonight and see what happens.