I believe I have seen this exact same problem as well.  Currently, I
work around this and two other serious problems I had (bug 148408 and
bug 187967) with the gutsy version by just downgrading xserver-xorg-
video-ati to feisty.

https://launchpad.net/ubuntu/feisty/i386/xserver-xorg-video-ati/1:6.6.3-2ubuntu6
https://launchpad.net/ubuntu/gutsy/i386/xserver-xorg-video-ati/1:6.7.195-1ubuntu2

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Ubuntu 7.10 won't use full capability of my ATI graphics card, only get 800x600 
now, 6.06 allowed higher resolutions
https://bugs.launchpad.net/bugs/162136
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