I success to reproduce this bug:

C:\test2>bzr init
Created a standalone tree (format: 2a)

C:\test2>echo abc > あいう

C:\test2>bzr add あいう
adding "あいう"

C:\test2>bzr commit -m "abc"
Committing to: C:/test2/
added あいう
Committed revision 1.

C:\test2>echo def >> あいう

C:\test2>bzr diff
=== modified file '縺ゅ＞縺・
--- 縺ゅ＞縺・2010-02-18 12:12:23 +0000
+++ 縺ゅ＞縺・2010-02-18 12:12:40 +0000
@@ -1,1 +1,2 @@
 abc
+def


C:\test2>bzr diff --using=C:\\usr\\WinMerge\\WinMergeU.exe
=== modified file '縺ゅ＞縺・
bzr: ERROR: exceptions.UnicodeEncodeError: 'ascii' codec can't encode characters in position 84-86: ordinal not in r
(128)

Traceback (most recent call last):
  File "bzrlib\commands.pyo", line 853, in exception_to_return_code
  File "bzrlib\commands.pyo", line 1055, in run_bzr
  File "bzrlib\commands.pyo", line 661, in run_argv_aliases
  File "bzrlib\commands.pyo", line 665, in run_direct
  File "bzrlib\cleanup.pyo", line 122, in run_simple
  File "bzrlib\cleanup.pyo", line 156, in _do_with_cleanups
  File "bzrlib\commands.pyo", line 1070, in ignore_pipe
  File "bzrlib\builtins.pyo", line 1955, in run
  File "bzrlib\diff.pyo", line 444, in show_diff_trees
  File "bzrlib\diff.pyo", line 889, in show_diff
  File "bzrlib\diff.pyo", line 949, in _show_diff
  File "bzrlib\diff.pyo", line 975, in _diff
  File "bzrlib\diff.pyo", line 506, in _diff_many
  File "bzrlib\diff.pyo", line 782, in diff
  File "bzrlib\diff.pyo", line 708, in _execute
  File "subprocess.pyo", line 594, in __init__
  File "subprocess.pyo", line 822, in _execute_child
UnicodeEncodeError: 'ascii' codec can't encode characters in position 84-86: ordinal not in range(128)

bzr 2.1.0 on python 2.5.4 (Windows-XP-5.1.2600-SP3)
arguments: ['bzr', 'diff', '--using=C:\\\\usr\\\\WinMerge\\\\WinMergeU.exe']
encoding: 'cp932', fsenc: 'mbcs', lang: 'ja'
plugins:
  bzrtools             C:\Program Files\Bazaar\plugins\bzrtools [2.1.0]
  explorer             C:\Documents and Settings\inada-n\Application Data\bazaar\2.0\plugins\explorer [1.0.0.rc.0]
  launchpad            C:\Program Files\Bazaar\plugins\launchpad [2.1.0]
  loom                 C:\Documents and Settings\inada-n\Application Data\bazaar\2.0\plugins\loom [1.4.0dev]
  netrc_credential_store C:\Program Files\Bazaar\plugins\netrc_credential_store [2.1.0]
  qbzr                 C:\Documents and Settings\inada-n\Application Data\bazaar\2.0\plugins\qbzr [0.19.0dev]
  rebase               C:\Program Files\Bazaar\plugins\rebase [0.5.5]
  scmproj              C:\Documents and Settings\inada-n\Application Data\bazaar\2.0\plugins\scmproj [0.6.0dev]
  svn                  C:\Program Files\Bazaar\plugins\svn [1.0.2]
  symlink              C:\Documents and Settings\inada-n\Application Data\bazaar\2.0\plugins\symlink [0.92.0]
  upload               C:\Program Files\Bazaar\plugins\upload [1.0.0dev]
  xmloutput            C:\Program Files\Bazaar\plugins\xmloutput [0.8.6]

*** Bazaar has encountered an internal error.  This probably indicates a
    bug in Bazaar.  You can help us fix it by filing a bug report at
        https://bugs.launchpad.net/bzr/+filebug
    including this traceback and a description of the problem.

Traceback is:
0.093  bazaar version: 2.1.0
0.093  bzr arguments: [u'diff', u'--using=C:\\\\usr\\\\WinMerge\\\\WinMergeU.exe']
0.109  looking for plugins in C:/Documents and Settings/inada-n/Application Data/bazaar/2.0/plugins
0.187  looking for plugins in C:/Program Files/Bazaar/plugins
0.187  Plugin name explorer already loaded
0.187  Plugin name qbzr already loaded
0.234  encoding stdout as sys.stdout encoding 'cp932'
0.250  opening working tree 'C:/test2'
0.281  Traceback (most recent call last):
  File "bzrlib\commands.pyo", line 853, in exception_to_return_code
  File "bzrlib\commands.pyo", line 1055, in run_bzr
  File "bzrlib\commands.pyo", line 661, in run_argv_aliases
  File "bzrlib\commands.pyo", line 665, in run_direct
  File "bzrlib\cleanup.pyo", line 122, in run_simple
  File "bzrlib\cleanup.pyo", line 156, in _do_with_cleanups
  File "bzrlib\commands.pyo", line 1070, in ignore_pipe
  File "bzrlib\builtins.pyo", line 1955, in run
  File "bzrlib\diff.pyo", line 444, in show_diff_trees
  File "bzrlib\diff.pyo", line 889, in show_diff
  File "bzrlib\diff.pyo", line 949, in _show_diff
  File "bzrlib\diff.pyo", line 975, in _diff
  File "bzrlib\diff.pyo", line 506, in _diff_many
  File "bzrlib\diff.pyo", line 782, in diff
  File "bzrlib\diff.pyo", line 708, in _execute
  File "subprocess.pyo", line 594, in __init__
  File "subprocess.pyo", line 822, in _execute_child
UnicodeEncodeError: 'ascii' codec can't encode characters in position 84-86: ordinal not in range(128)