Using a newer virtualenv, 1.3.3 does NOT solve this issue.

gavin@asfolath ~/P/butcher> virtualenv -v .
Creating ./lib/python2.6
Symlinking Python bootstrap modules
  Symlinking ./lib/python2.6/types.pyc
  Symlinking ./lib/python2.6/copy_reg.pyc
  Symlinking ./lib/python2.6/sre_constants.py
  Symlinking ./lib/python2.6/os.pyc
  Symlinking ./lib/python2.6/stat.py
  Symlinking ./lib/python2.6/warnings.pyc
  Symlinking ./lib/python2.6/encodings
  Symlinking ./lib/python2.6/sre.pyc
  Symlinking ./lib/python2.6/fnmatch.py
  Symlinking ./lib/python2.6/re.py
  Symlinking ./lib/python2.6/sre_compile.py
  Symlinking ./lib/python2.6/linecache.pyc
  Symlinking ./lib/python2.6/UserDict.pyc
  Symlinking ./lib/python2.6/lib-dynload
  Symlinking ./lib/python2.6/types.py
  Symlinking ./lib/python2.6/config
  Symlinking ./lib/python2.6/copy_reg.py
  Symlinking ./lib/python2.6/genericpath.py
  Symlinking ./lib/python2.6/sre_parse.pyc
  Symlinking ./lib/python2.6/abc.py
  Symlinking ./lib/python2.6/sre_constants.pyc
  Symlinking ./lib/python2.6/re.pyc
  Symlinking ./lib/python2.6/sre.py
  Symlinking ./lib/python2.6/locale.pyc
  Symlinking ./lib/python2.6/fnmatch.pyc
  Symlinking ./lib/python2.6/genericpath.pyc
  Symlinking ./lib/python2.6/warnings.py
  Symlinking ./lib/python2.6/stat.pyc
  Symlinking ./lib/python2.6/os.py
  Symlinking ./lib/python2.6/codecs.pyc
  Symlinking ./lib/python2.6/ntpath.py
  Symlinking ./lib/python2.6/abc.pyc
  Symlinking ./lib/python2.6/locale.py
  Symlinking ./lib/python2.6/_abcoll.pyc
  Symlinking ./lib/python2.6/posixpath.pyc
  Symlinking ./lib/python2.6/sre_compile.pyc
  Symlinking ./lib/python2.6/ntpath.pyc
  Symlinking ./lib/python2.6/UserDict.py
  Symlinking ./lib/python2.6/posixpath.py
  Symlinking ./lib/python2.6/linecache.py
  Symlinking ./lib/python2.6/sre_parse.py
  Symlinking ./lib/python2.6/_abcoll.py
  Symlinking ./lib/python2.6/codecs.py
Creating ./lib/python2.6/site-packages
Writing ./lib/python2.6/site.py
Writing ./lib/python2.6/orig-prefix.txt
Creating parent directories for ./include
Symlinking ./include/python2.6
Creating ./bin
New python executable in ./bin/python
Changed mode of ./bin/python to 0755
Testing executable with ./bin/python -c "import sys; print sys.prefix"
Got sys.prefix result: '/home/gavin/Programing/butcher'
Creating ./lib/python2.6/distutils
Writing ./lib/python2.6/distutils/__init__.py
Writing ./lib/python2.6/distutils/distutils.cfg
Using existing Setuptools egg: /usr/local/lib/python2.6/dist-packages/virtualenv-1.3.3-py2.6.egg/support-files/setuptools-0.6c9-py2.6.egg
Installing setuptools...
  error: can't create or remove files in install directory
  The following error occurred while trying to add or remove files in the
  installation directory:
      [Errno 2] No such file or directory: '/home/gavin/Programing/butcher/local/lib/python2.6/dist-packages/test-easy-install-7933.pth'
  The installation directory you specified (via --install-dir, --prefix, or
  the distutils default setting) was:
      /home/gavin/Programing/butcher/local/lib/python2.6/dist-packages/
  This directory does not currently exist.  Please create it and try again, or
  choose a different installation directory (using the -d or --install-dir
  option).
  Complete output from command ./bin/python -c "#!python
\"\"\"Bootstrap setuptoo...




" /usr/local/lib/python2.6/dist-...6.egg:
  error: can't create or remove files in install directory

The following error occurred while trying to add or remove files in the
installation directory:

    [Errno 2] No such file or directory: '/home/gavin/Programing/butcher/local/lib/python2.6/dist-packages/test-easy-install-7933.pth'

The installation directory you specified (via --install-dir, --prefix, or
the distutils default setting) was:

    /home/gavin/Programing/butcher/local/lib/python2.6/dist-packages/

This directory does not currently exist.  Please create it and try again, or
choose a different installation directory (using the -d or --install-dir
option).

----------------------------------------
...Installing setuptools...done.
Traceback (most recent call last):
  File "/usr/local/bin/virtualenv", line 8, in <module>
    load_entry_point('virtualenv==1.3.3', 'console_scripts', 'virtualenv')()
  File "/usr/local/lib/python2.6/dist-packages/virtualenv-1.3.3-py2.6.egg/virtualenv.py", line 420, in main
    unzip_setuptools=options.unzip_setuptools)
  File "/usr/local/lib/python2.6/dist-packages/virtualenv-1.3.3-py2.6.egg/virtualenv.py", line 507, in create_environment
    install_setuptools(py_executable, unzip=unzip_setuptools)
  File "/usr/local/lib/python2.6/dist-packages/virtualenv-1.3.3-py2.6.egg/virtualenv.py", line 295, in install_setuptools
    cwd=cwd)
  File "/usr/local/lib/python2.6/dist-packages/virtualenv-1.3.3-py2.6.egg/virtualenv.py", line 481, in call_subprocess
    % (cmd_desc, proc.returncode))
OSError: Command ./bin/python -c "#!python
\"\"\"Bootstrap setuptoo...




" /usr/local/lib/python2.6/dist-...6.egg failed with error code 1


Instead of the import errors as seen above, virtualenv now fails to finish as something goes wrong with the setuptools install path. It's trying to install the egg in ./local/lib/... while it should be installing it in ./lib/...

I think this is might related changes in the python path made in Jaunty?