Right, Tony.

With the use of a proxy server, a local host file does absolutely nothing regarding the elimination of ads. If you use a proxy (and didn't specifically disable it for the advertising hosts), your webbrowser just asks the proxy for the complete URL, and the proxy does all the DNS lookup etc.
I haven't tried the following (so it might just as well not work), but assuming that you are using IE as your browser, go to IE's proxy settings (for LAN connection, I suppose) and enable the checkbox "disable proxy for local adresses" (might be named different, but you get the idea). That _might_ disable the proxy for any hosts that resolves to 127.0.0.1 if it doesn't, you might try to go into advanced proxy options and add 127.0.0.1 to the list of hosts that you don't want IE to use the proxy for (disable proxy for hosts starting with... setting).

cu,
sven