Unwanted Popups and Disabled Control Panel

Hi, For the last few days, I keep getting a pop up every 5 minutes saying

Windows Security Alert "warning! potential spyware operation! Your computer is making unauthorized copies of your system and Internet files. Run full scan now to pervent any unathorised access to your files! Click YES to download spyware remover ... "

I use AVG Free edition, and it recognized the virus, named "Trojan Horse Downloader.Small.AJY", and put it in the Vault.
But there is one file that AVG also found, but it says the file is not a threat. This one:

C:\WINDOWS\System 32\drivers\etc\hosts

So I still have 2 problems:
1. the incessant popup mentioned above, and
2. I cannot access things like my Control Panel, or the Date function at the bottom right corner, there is a Restrictions error message saying:

"This operation has been cancelled due to restrictions in effect on this computer. Please contact your system administrator".

It seems the 'hosts' file is the problem, but is something important so I likely shouldn't delete it.I have done a few things like installing and running AVG Anti-Spyware 7.5 in safe mode, and it detected a few things and put them into Quarantine, but the problem persists. The other apps I used didn't find much.

Well but thanks to ComboFix which fixed all my problems and that too without affecting my system. Perform the following steps to fix this problem:

1. Download ComboFix from one of the links below:
http://www.techsupportforum.com/sectools/sUBs/ComboFix.exe
http://download.bleepingcomputer.com/sUBs/ComboFix.exe
2. Double click combofix.exe & follow the prompts.

Note: Do not mouseclick combofix's window while it's running. That may cause it to stop.

ComboFix will create a folder called QooBox in C: (C:\QooBox). It will contain any folders that were quarantined. When you are done you can delete this folder - QooBox.