For reference I tried the same exercise last night with Word 2003 and it worked exactly as I expected. The links all worked fine, that was using "Save as webpage" rather than "Save as text".
I'm sure it is possible to replicate the problem reported by tying IE's security settings for the local zone, maybe that is what has happened here.
Oh and this is what a simple HTML file with one link looks like by the time Word 2003 has had it's way with it:
<html xmlns:o="urn:schemas-microsoft-com:office:office"
xmlns:w="urn:schemas-microsoft-com:office:word"
xmlns="http://www.w3.org/TR/REC-html40">
<head>
<meta http-equiv=Content-Type content="text/html; charset=windows-1252">
<meta name=ProgId content=Word.Document>
<meta name=Generator content="Microsoft Word 11">
<meta name=Originator content="Microsoft Word 11">
<link rel=File-List href="C_files/filelist.xml">
<title>C:\test</title>
<!--[if gte mso 9]><xml>
<o:DocumentProperties>
<o:Author>Andrew Norman</o:Author>
<o:LastAuthor>Andrew Norman</o:LastAuthor>
<o:Revision>2</o:Revision>
<o:TotalTime>2</o:TotalTime>
<o:Created>2007-11-25T18:16:00Z</o:Created>
<o:LastSaved>2007-11-25T18:16:00Z</o:LastSaved>
<o:Pages>1</o:Pages>
<o:Words>6</o:Words>
<o:Characters>36</o:Characters>
<o:Company>Microsign Technology Ltd</o:Company>
<o:Lines>1</o:Lines>
<o:Paragraphs>1</o:Paragraphs>
<o:CharactersWithSpaces>41</o:CharactersWithSpaces>
<o:Version>11.8132</o:Version>
</o:DocumentProperties>
</xml><![endif]--><!--[if gte mso 9]><xml>
<w:WordDocument>
<w:DontDisplayPageBoundaries/>
<w:GrammarState>Clean</w:GrammarState>
<w:PunctuationKerning/>
<w:ValidateAgainstSchemas/>
<w:SaveIfXMLInvalid>false</w:SaveIfXMLInvalid>
<w:IgnoreMixedContent>false</w:IgnoreMixedContent>
<w:AlwaysShowPlaceholderText>false</w:AlwaysShowPlaceholderText>
<w:Compatibility>
<w:BreakWrappedTables/>
<w:SnapToGridInCell/>
<w:WrapTextWithPunct/>
<w:UseAsianBreakRules/>
<w:DontGrowAutofit/>
</w:Compatibility>
<w:BrowserLevel>MicrosoftInternetExplorer4</w:BrowserLevel>
</w:WordDocument>
</xml><![endif]--><!--[if gte mso 9]><xml>
<w:LatentStyles DefLockedState="false" LatentStyleCount="156">
</w:LatentStyles>
</xml><![endif]-->
<style>
<!--
/* Style Definitions */
p.MsoNormal, li.MsoNormal, div.MsoNormal
{mso-style-parent:"";
margin:0cm;
margin-bottom:.0001pt;
mso-pagination:widow-orphan;
font-size:12.0pt;
font-family:"Times New Roman";
mso-fareast-font-family:"Times New Roman";}
a:link, span.MsoHyperlink
{color:blue;
text-decoration:underline;
text-underline:single;}
a:visited, span.MsoHyperlinkFollowed
{color:purple;
text-decoration:underline;
text-underline:single;}
@page Section1
{size:595.3pt 841.9pt;
margin:72.0pt 90.0pt 72.0pt 90.0pt;
mso-header-margin:35.4pt;
mso-footer-margin:35.4pt;
mso-paper-source:0;}
div.Section1
{page:Section1;}
-->
</style>
<!--[if gte mso 10]>
<style>
/* Style Definitions */
table.MsoNormalTable
{mso-style-name:"Table Normal";
mso-tstyle-rowband-size:0;
mso-tstyle-colband-size:0;
mso-style-noshow:yes;
mso-style-parent:"";
mso-padding-alt:0cm 5.4pt 0cm 5.4pt;
mso-para-margin:0cm;
mso-para-margin-bottom:.0001pt;
mso-pagination:widow-orphan;
font-size:10.0pt;
font-family:"Times New Roman";
mso-ansi-language:#0400;
mso-fareast-language:#0400;
mso-bidi-language:#0400;}
</style>
<![endif]-->
</head>
<body lang=EN-GB link=blue vlink=purple style='tab-interval:36.0pt'>
<div class=Section1>
<p class=MsoNormal><a href="../../../test.htm">C:\test.htm</a></p>
</div>
</body>
</html>
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